Preface: To the Instructor vii Preface: To the Student xix Introduction 1 Ten Principles of Economics 3 How People Make Decisions 4 People Face Trade-offs 4 The Cost of Something Is What You Give Up to Get It 5 Rational People Think at the Margin 6 People Respond to Incentives 7 How People Interact 8 Trade Can Make Everyone Better Off 8 Markets Are Usually a Good Way to Organize Economic Activity 9 Governments Can Sometimes Improve Market Outcomes 10 FYI: Adam Smith and the Invisible Hand 10 How the Economy as a Whole Works 11 A Country's Standard of Living Depends on Its Ability to Produce Goods and Services 12 Prices Rise When the Government Prints Too Much Money 12 Society Faces a Short-Run Trade-off between Inflation and Unemployment 13 FYI: How to Read This Book 14 Conclusion 14 Summary 15 Key Concepts 15 Questions for Review 16 Problems and Applications 16 Thinking Like an Economist 19 TheEconomist as Scientist 20 The Scientific Method: Observation, Theory and More Observation 20 The Role of Assumptions 21 Economic Models 22 Our First Model: The Circular-Flow Diagram 22 Our Second Model: The Production Possibilities Frontier 24 Microeconomics and Macroeconomics 26 FYI: Who Studies Economics? 27 The Economist as Policy Adviser 28 Positive versus Normative Analysis 28 Economists in Washington 29 In the News: Super Bowl Economics 30 Case Study: Mr. Mankiw Goes to Washington 31 Why Economists Disagree 32 Differences in Scientific Judgments 32 Differences in Values 33 Perception versus Reality 33 Let's Get Going 34 In the News: Why You Should Study Economics 35 Summary 36 Key Concepts 36 Questions for Review 36 Problems and Applications 36 Graphing: A Brief Review 38 Graphs of a Single Variable 38 Graphs of Two Variables: The Coordinate System 39 Curves in the Coordinate System 40 Slope 42 Cause and Effect 44 Interdependence and the Gains From Trade 47 A Parable for the Modern Economy 48 Production Possibilities 48 Specialization and Trade 50 Comparative Advantage: The Driving Force of Specialization 52 Absolute Advantage 52 Opportunity Cost and Comparative Advantage 52 Comparative Advantage and Trade 54 FYI: The Legacy of Adam Smith and David Ricardo 55 Applications of Comparative Advantage 55 Should Tiger Woods Mow His Own Lawn? 55 In the News: Evolution and Economics 56 Should the United States Trade with Other Countries? 56 Conclusion 58 Summary 58 Key Concepts 59 Questions for Review 59 Problems and Applications 59 How Markets Work 61 The Market Forces of Supply and Demand 63 Markets and Competition 64 What Is a Market? 64 What Is Competition? 64 Demand 65 The Demand Curve: The Relationship between Price and Quantity Demanded 65 Market Demand versus Individual Demand 66 Shifts in the Demand Curve 67 Case Study: Two Ways to Reduce the Quantity of Smoking Demanded 69 Supply 71 The Supply Curve: The Relationship between Price and Quantity Supplied 71 Market Supply versus Individual Supply 71 Shifts in the Supply Curve 72 Supply and Demand Together 75 Equilibrium 75 Three Steps to Analyzing Changes in Equilibrium 77 In the News: Political Unrest Shifts the Supply Curve 81 Conclusion: How Prices Allocate Resources 82 Summary 84 Key Concepts 84 Questions for Review 85 Problems and Applications 85 Elasticity and its Application 89 The Elasticity of Demand 90 The Price Elasticity of Demand and Its Determinants 90 Computing the Price Elasticity of Demand 91 The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities 92 The Variety of Demand Curves 93 Total Revenue and the Price Elasticity of Demand 93 Elasticity and Total Revenue along a Linear Demand Curve 95 In the News: On the Road with Elasticity 98 Other Demand Elasticities 98 The Elasticity of Supply 99 The Price Elasticity of Supply and Its Determinants 100 Computing the Price Elasticity of Supply 100 The Variety of Supply Curves 100 Three Applications of Supply, Demand, and Elasticity 103 Can Good News for Farming Be Bad News for Farmers? 103 Why Did OPEC Fail to Keep the Price of Oil High? 105 Does Drug Interdiction Increase or Decrease Drug-Related Crime? 107 Conclusion 108 Summary 109 Key Concepts 109 Questions for Review 109 Problems and Applications 110 Supply, Demand, and Government Policies 113 Controls on Prices 114 How Price Ceilings Affect Market Outcomes 114 Case Study: Lines at the Gas Pump 116 Case Study: Rent Control in the Short Run and Long Run 117 How Price Floors Affect Market Outcomes 118 In the News: Rent Control in New York 120 Case Study: The Minimum Wage 120 Evaluating Price Controls 123 Taxes 124 How Taxes on Buyers Affect Market Outcomes 124 How Taxes on Sellers Affect Market Outcomes 126 Case Study: Can Congress Distribute the Burden of a Payroll Tax? 128 Elasticity and Tax Incidence 129 Case Study: Who Pays the Luxury Tax? 129 Conclusion 131 Summary 131 Key Concepts 132 Questions for Review 132 Problems and Applications 132 Markets and Welfare 135 Consumers, Producers, and the Efficiency of Markets 137 Consumer Surplus 138 Willingness to Pay 138 Using the Demand Curve to Measure Consumer Surplus 139 How a Lower Price Raises Consumer Surplus 140 What Does Consumer Surplus Measure? 142 Producer Surplus 143 Cost and the Willingness to Sell 143 Using the Supply Curve to Measure Producer Surplus 144 How a Higher Price Raises Producer Surplus 146 Market Efficiency 147 The Benevolent Social Planner 147 Evaluating the Market Equilibrium 148 In the News: Ticket Scalping 151 Case Study: Should There Be a Market in Organs? 152 In the News: The Miracle of the Market 153 Conclusion: Market Efficiency and Market Failure 154 Summary 155 Key Concepts 155 Questions for Review 155 Problems and Applications 156 Application: The Costs of Taxation 159 The Deadweight Loss of Taxation 160 How a Tax Affects Market Participants 161 Deadweight Losses and the Gains from Trade 163 The Determinants of the Deadweight Loss 165 Case Study: The Deadweight Loss Debate 165 Deadweight Loss and Tax Revenue as Taxes Vary 167 FYI: Henry George and the Land Tax 169 Case Study: The Laffer Curve and Supply-Side Economics 170 In the News: On the Way to France 171 Conclusion 172 Summary 173 Key Concept 173 Questions for Review 173 Problems and Applications 173 Application: International Trade 177 The Determinants of Trade 178 The Equilibrium without Trade 178 The World Price and Comparative Advantage 179 The Winners and Losers from Trade 179 The Gains and Losses of an Exporting Country 180 The Gains and Losses of an Importing Country 181 In the News: Cheap Clothes from China 183 The Effects of a Tariff 184 FYI: Import Quotas: Another Way to Restrict Trade 186 The Lessons for Trade Policy 186 The Arguments for Restricting Trade 187 FYI: Other Benefits of International Trade 188 The Jobs Argument 188 In the News: Offshore Outsourcing 189 The National-Security Argument 190 The Infant-Industry Argument 190 The Unfair-Competition Argument 191 The Protection-as-a-Bargaining-Chip Argument 191 Case Study: Trade Agreements and the World Trade Organization 192 In the News: Globalization 193 Conclusion 194 Summary 195 Key Concepts 195 Questions for Review 196 Problems and Applications 196 The Economics of the Public Sector 201 Externalities 203 Externalities and Market Inefficiency 204 Welfare Economics: A Recap 205 Negative Externalities 206 Positive Externalities 207 Case Study: Technology Spillovers, Industrial Policy, and Patent Protection 208 Private Solutions to Externalities 209 The Types of Private Solutions 209 The Coase Theorem 210 Why Private Solutions Do Not Always Work 211 Public Policies toward Externalities 212 Command-and-Control Policies: Regulation 212 Market-Based Policy 1: Corrective Taxes and Subsidies 213 In the News: Conserving Fuel 214 Case Study: Why Is Gasoline Taxed So Heavily? 215 Market-Based Policy 2: Tradable Pollution Permits 216 In the News: Controlling Carbon 218 Objections to the Economic Analysis of Pollution 219 Conclusion 219 Summary 220 Key Concepts 220 Questions for Review 220 Problems and Applications 221 Public Goods and Common Resources 223 The Different Kinds of Goods 224 Public Goods 225 The Free-Rider Problem 226 Some Important Public Goods 226 Case Study: Are Lighthouses Public Goods? 228 The Difficult Job of Cost-Benefit Analysis 229 Case Study: How Much Is a Life Worth? 230 Common Resources 231 The Tragedy of the Commons 231 Some Important Common Resources 232 In the News: A Solution to City Congestion 233 Case Study: Why the Cow Is Not Extinct 234 In the News: Should Yellowstone Charge as Much as Disney World? 235 Conclusion: The Importance of Property Rights 236 Summary 236 Key Concepts 237 Questions for Review 237 Problems and Applications 237 The Design of the Tax System 241 A Financial Overview of the U.S. Government 242 The Federal Government 242 Case Study: The Fiscal Challenge Ahead 246 State and Local Government 248 Taxes and Efficiency 249 Deadweight Losses 250 Case Study: Should Income or Consumption Be Taxed? 250 Administrative Burden 251 Marginal Tax Rates versus Average Tax Rates 252 Case Study: Iceland's Natural Experiment 252 Lump-Sum Taxes 253 Taxes and Equity 253 The Benefits Principle 254 The Ability-to-Pay Principle 254 Case Study: How the Tax Burden Is Distributed 255 In the News: Tax Reform around the World 257 Case Study: Horizontal Equity and the Marriage Tax 257 Tax Incidence and Tax Equity 259 Case Study: Who Pays the Corporate Income Tax? 259 Conclusion: The Trade-off between Equity and Efficiency 260 Summary 261 Key Concepts 261 Questions for Review 261 Problems and Applications 262 Firm Behavior and the Organization of Industry 265 The Costs of Production 267 What Are Costs? 268 Total Revenue, Total Cost, and Profit 268 Costs as Opportunity Costs 268 The Cost of Capital as an Opportunity Cost 269 Economic Profit versus Accounting Profit 270 Production and Costs 271 The Production Function 271 From the Production Function to the Total-Cost Curve 273 The Various Measures of Cost 274 Fixed and Variable Costs 275 Average and Marginal Cost 276 Cost Curves and Their Shapes 277 Typical Cost Curves 278 Costs in the Short Run and in the Long Run 280 The Relationship between Short-Run and Long-Run Average Total Cost 280 Economies and Diseconomies of Scale 281 FYI: Lessons from a Pin Factory 282 Conclusion 282 Summary 283 Key Concepts 284 Questions for Review 284 Problems and Applications 285 Firms in Competitive Markets 289 What Is a Competitive Market? 290 The Meaning of Competition 290 The Revenue of a Competitive Firm 290 Profit Maximization and the Competitive Firm's Supply Curve 292 A Simple Example of Profit Maximization 292 The Marginal-Cost Curve and the Firm's Supply Decision 293 The Firm's Short-Run Decision to Shut Down 295 Spilt Milk and Other Sunk Costs 297 Case Study: Near-Empty Restaurants and Off-season Miniature Golf 298 The Firm's Long-Run Decision to Exit or Enter a Market 298 Measuring Profit in Our Graph for the Competitive Firm 299 The Supply Curve in a Competitive Market 301 The Short Run: Market Supply with a Fixed Number of Firms 301 The Long Run: Market Supply with Entry and Exit 302 Why Do Competitive Firms Stay in Business If They Make Zero Profit? 303 A Shift in Demand in the Short Run and Long Run 304 Why the Long-Run Supply Curve Might Slope Upward 304 Conclusion: Behind the Supply Curve 306 Summary 307 Key Concepts 307 Questions for Review 307 Problems and Applications 308 Monopoly 311 Why Monopolies Arise 312 Monopoly Resources 313 Case Study: The DeBeers Diamond Monopoly 313 Government-Created Monopolies 313 Natural Monopolies 314 How Monopolies Make Production and Pricing Decisions 315 Monopoly versus Competition 316 A Monopoly's Revenue 317 Profit Maximization 318 A Monopoly's Profit 320 FYI: Why a Monopoly Does Not Have a Supply Curve 321 Case Study: Monopoly Drugs versus Generic Drugs 322 The Welfare Cost of Monopoly 323 The Deadweight Loss 323 The Monopoly's Profit: A Social Cost? 325 Public Policy toward Monopolies 326 Increasing Competition with Antitrust Laws 326 Regulation 327 Public Ownership 328 Doing Nothing 329 Price Discrimination 329 In the News: Public Transport and Private Enterprise 330 A Parable about Pricing 330 The Moral of the Story 332 The Analytics of Price Discrimination 333 Examples of Price Discrimination 334 Conclusion: The Prevalence of Monopoly 335 In the News: TKTS and Other Schemes 336 Summary 338 Key Concepts 339 Questions for Review 339 Problems and Applications 340 Oligopoly 345 Between Monopoly and Perfect Competition 346 Markets with Only a Few Sellers 347 In the News: The Growth of Oligopoly 348 A Duopoly Example 348 Competition, Monopolies, and Cartels 349 The Equilibrium for an Oligopoly 350 In the News: The Global Fight against Cartels 351 How the Size of an Oligopoly Affects the Market Outcome 352 Game Theory and the Economics of Cooperation 353 The Prisoners' Dilemma 354 Oligopolies as a Prisoners' Dilemma 355 Case Study: OPEC and the World Oil Market 356 Other Examples of the Prisoners' Dilemma 357 The Prisoners' Dilemma and the Welfare of Society 359 Why People Sometimes Cooperate 359 Case Study: The Prisoners' Dilemma Tournament 360 Public Policy toward Oligopolies 360 Restraint of Trade and the Antitrust Laws 361 Case Study: An Illegal Phone Call 361 Controversies over Antitrust Policy 362 Case Study: The Microsoft Case 364 Conclusion 365 In the News: Antitrust in the New Economy 366 Summary 367 Key Concepts 367 Questions for Review 367 Problems and Applications 368 Monopolistic Competition 373 Competition with Differentiated Products 374 The Monopolistically Competitive Firm in the Short Run 374 The Long-Run Equilibrium 375 Monopolistic versus Perfect Competition 377 Monopolistic Competition and the Welfare of Society 379 FYI: Is Excess Capacity a Social Problem? 380 Advertising 380 The Debate over Advertising 381 Case Study: Advertising and the Price of Eyeglasses 382 Advertising as a Signal of Quality 382 FYI: Galbraith versus Hayek 383 Brand Names 384 Conclusion 386 Summary 387 Key Concept 387 Questions for Review 387 Problems and Applications 388 The Economics of Labor Markets 391 The Markets for the Factors of Production 393 The Demand for Labor 394 The Competitive Profit-Maximizing Firm 394 The Production Function and the Marginal Product of Labor 395 The Value of the Marginal Product and the Demand for Labor 397 What Causes the Labor-Demand Curve to Shift? 398 FYI: Input Demand and Output Supply: Two Sides of the Same Coin 399 FYI: The Luddite Revolt 400 The Supply of Labor 401 The Trade-off between Work and Leisure 401 What Causes the Labor-Supply Curve to Shift? 401 Equilibrium in the Labor Market 402 Shifts in Labor Supply 402 Shifts in Labor Demand 404 Case Study: Productivity and Wages 405 FYI: Monopsony 406 The Other Factors of Production: Land and Capital 406 Equilibrium in the Markets for Land and Capital 407 FYI: What Is Capital Income? 408 Linkages among the Factors of Production 408 Case Study: The Economics of the Black Death 409 Conclusion 410 Summary 410 Key Concepts 410 Questions for Review 411 Problems and Applications 411 Earnings and Discrimination 413 Some Determinants of Equilibrium Wages 414 Compensating Differentials 414 Human Capital 414 Case Study: The Increasing Value of Skills 415 Ability Effort, and Chance 416 In the News: The Loss of Manufacturing Jobs 417 Case Study: The Benefits of Beauty 418 An Alternative View of Education: Signaling 419 The Superstar Phenomenon 419 In the News: Are Elite Colleges Worth the Cost? 420 Above-Equilibrium Wages: Minimum-Wage Laws, Unions, and Efficiency Wages 421 The Economics of Discrimination 422 Measuring Labor-Market Discrimination 422 Case Study: Is Emily More Employable than Lakisha? 424 Discrimination by Employers 424 Case Study: Segregated Streetcars and the Profit Motive 425 Discrimination by Customers and Governments 426 Case Study: Discrimination in Sports 426 Conclusion 427 Summary 428 Key Concepts 428 Questions for Review 428 Problems and Applications 429 Income Inequality and Poverty 431 The Measurement of Inequality 432 U.S. Income Inequality 432 Inequality around the World 433 The Poverty Rate 434 In the News: The Global Distribution of Income 435 Problems in Measuring Inequality 437 Economic Mobility 438 The Political Philosophy of Redistributing Income 439 Utilitarianism 439 Liberalism 440 Libertarianism 441 Policies to Reduce Poverty 442 Minimum-Wage Laws 442 Welfare 443 In the News: Hurricane Katrina and Its Aftermath 444 Negative Income Tax 444 In-Kind Transfers 445 In the News: Child Labor 446 Antipoverty Programs and Work Incentives 447 Conclusion 449 Summary 450 Key Concepts 450 Questions for Review 450 Problems and Applications 451 Topics for Further Study 453 The Theory of Consumer Choice 455 The Budget Constraint: What the Consumer Can Afford 456 Preferences: What the Consumer Wants 457 Representing Preferences with Indifference Curves 458 Four Properties of Indifference Curves 459 Two Extreme Examples of Indifference Curves 460 Optimization: What the Consumer Chooses 462 The Consumer's Optimal Choices 462 FYI: Utility: An Alternative Way to Describe Preferences and Optimization 463 How Changes in Income Affect the Consumer's Choices 464 How Changes in Prices Affect the Consumer's Choices 465 Income and Substitution Effects 466 Deriving the Demand Curve 468 Three Applications 469 Do All Demand Curves Slope Downward? 469 How Do Wages Affect Labor Supply? 471 Case Study: Income Effects on Labor Supply: Historical Trends, Lottery Winners, and the Carnegie Conjecture 472 How Do Interest Rates Affect Household Saving? 474 Conclusion: Do People Really Think This Way? 477 Summary 478 Key Concepts 478 Questions for Review 478 Problems and Applications 479 Frontiers of Microeconomics 483 Asymmetric Information 484 Hidden Actions: Principals, Agents, and Moral Hazard 484 Case Study: Corporate Management 485 Hidden Characteristics: Adverse Selection and the Lemons Problem 486 In the News: The Fruits of Moral Hazard 487 Signaling to Convey Private Information 487 Case Study: Gifts as Signals 488 Screening to Induce Information Revelation 489 Asymmetric Information and Public Policy 489 Political Economy 490 The Condorcet Voting Paradox 490 Arrow's Impossibility Theorem 491 The Median Voter Is King 492 In the News: Farm Policy and Politics 494 Politicians Are People Too 494 Behavioral Economics 496 People Aren't Always Rational 496 People Care about Fairness 497 People Are Inconsistent over Time 498 Conclusion 499 In the News: The Psychology of Saving 500 Summary 501 Key Concepts 501 Questions for Review 501 Problems and Applications 501 The Data of Macroeconomics 505 Measuring a Nation's Income 507 The Economy's Income and Expenditure 508 The Measurement of Gross Domestic Product 510 "GDP Is the Market Value..." 510 "...Of All..." 510 "...Final..." 511 "...Goods and Services..." 511 "...Produced..." 511 "...Within a Country..." 511 "...In a Given Period of Time" 511 The Components of GDP 512 Consumption 512 FYI: Other Measures of Income 513 Investment 513 Government Purchases 514 Net Exports 514 Case Study: The Components of U.S. GDP 515 Real versus Nominal GDP 515 A Numerical Example 516 The GDP Deflator 517 Case Study: Real GDP over Recent History 518 In the News: GDP Lightens Up 519 In the News: The Underground Economy 520 Is GDP a Good Measure of Economic Well-Being? 520 Case Study: International Differences in GDP and the Quality of Life 522 Case Study: Who Wins at the Olympics? 523 Conclusion 524 Summary 525 Key Concepts 525 Questions for Review 525 Problems and Applications 526 Measuring the Cost of Living 529 The Consumer Price Index 530 How the Consumer Price Index Is Calculated 530 Problems in Measuring the Cost of Living 532 FYI: What Is in the CPI's Basket? 533 In the News: Accounting for Quality Change 534 The GDP Deflator versus the Consumer Price Index 536 Correcting Economic Variables for the Effects of Inflation 538 Dollar Figures from Different Times 538 Case Study: Mr. Index Goes to Hollywood 539 Indexation 539 Real and Nominal Interest Rates 540 Case Study: Interest Rates in the U.S. Economy 541 Conclusion 542 Summary 543 Key Concepts 544 Questions for Review 544 Problems and Applications 544 The Real Economy in the Long Run 547 Production and Growth 549 Economic Growth around the World 550 FYI: A Picture Is Worth a Thousand Statistics 552 FYI: Are You Richer Than the Richest American? 554 Productivity: Its Role and Determinants 554 Why Productivity Is So Important 554 How Productivity Is Determined 555 FYI: The Production Function 557 Case Study: Are Natural Resources a Limit to Growth? 557 Economic Growth and Public Policy 558 Saving and Investment 559 Diminishing Returns and the Catch-Up Effect 559 Investment from Abroad 561 Education 562 Health and Nutrition 562 In the News: Promoting Human Capital 563 Property Rights and Political Stability 564 Free Trade 565 Research and Development 566 Population Growth 566 In the News: Rich Farmers versus the World's Poor 567 In the News: Foreign Aid 568 Conclusion: The Importance of Long-Run Growth 571 Summary 571 Key Concepts 572 Questions for Review 572 Problems and Applications 572 Saving, Investment, and the Financial System 575 Financial Institutions in the U.S. Economy 576 Financial Markets 576 Financial Intermediaries 578 FYI: How to Read the Newspaper's Stock Tables 579 Summing Up 581 Saving and Investment in the National Income Accounts 581 Some Important Identities 582 The Meaning of Saving and Investment 583 The Market for Loanable Funds 584 Supply and Demand for Loanable Funds 584 Saving Incentives 586 Investment Incentives 587 Government Budget Deficits and Surpluses 588 Case Study: The History of U.S. Government Debt 590 Conclusion 592 Summary 593 Key Concepts 593 Questions for Review 593 Problems and Applications 594 The Basic Tools of Finance 597 Present Value: Measuring the Time Value of Money 598 FYI: The Magic of Compounding and the Rule of 70 600 Managing Risk 600 Risk Aversion 600 The Markets for Insurance 601 FYI: The Peculiarities of Health Insurance 602 Diversification of Firm-Specific Risk 603 The Trade-off between Risk and Return 604 Asset Valuation 605 Fundamental Analysis 606 The Efficient Markets Hypothesis 606 Case Study: Random Walks and Index Funds 607 In the News: Nobel Caliber Investment Advice 608 Market Irrationality 609 Conclusion 609 Summary 610 Key Concepts 610 Questions for Review 610 Problems and Applications 611 Unemployment 613 Identifying Unemployment 614 How Is Unemployment Measured? 614 Case Study: Labor-Force Participation of Men and Women in the U.S. Economy 617 Does the Unemployment Rate Measure What We Want It To? 618 In the News: The Rise of Adult Male Joblessness 620 How Long Are the Unemployed without Work? 620 Why Are There Always Some People Unemployed? 622 Job Search 623 Why Some Frictional Unemployment Is Inevitable 623 Public Policy and Job Search 623 In the News: German Unemployment 624 Unemployment Insurance 626 Minimum-Wage Laws 627 FYI: Who Earns the Minimum Wage? 628 Unions and Collective Bargaining 629 The Economics of Unions 629 Are Unions Good or Bad for the Economy? 630 In the News: Should You Join a Union? 631 The Theory of Efficiency Wages 632 Worker Health 632 Worker Turnover 632 Worker Quality 633 Worker Effort 633 Case Study: Henry Ford and the Very Generous {dollar}5-a-Day Wage 634 Conclusion 634 Summary 635 Key Concepts 635 Questions for Review 636 Problems and Applications 636 Money and Prices in the Long Run 639 The Monetary System 641 The Meaning of Money 642 The Functions of Money 642 The Kinds of Money 643 In the News: The History of Money 644 Money in the U.S. Economy 645 FYI: Credit Cards, Debit Cards, and Money 647 Case Study: Where Is All the Currency? 647 The Federal Reserve System 648 The Fed's Organization 648 The Federal Open Market Committee 649 Banks and the Money Supply 650 The Simple Case of 100-Percent-Reserve Banking 650 Money Creation with Fractional-Reserve Banking 651 The Money Multiplier 652 The Fed's Tools of Monetary Control 653 Problems in Controlling the Money Supply 655 Case Study: Bank Runs and the Money Supply 655 FYI: The Federal Funds Rate 656 Conclusion 657 Summary 657 Key Concepts 658 Questions for Review 658 Problems and Applications 658 Money Growth and Inflation 661 The Classical Theory of Inflation 662 The Level of Prices and the Value of Money 662 Money Supply, Money Demand, and Monetary Equilibrium 663 The Effects of a Monetary Injection 664 A Brief Look at the Adjustment Process 665 The Classical Dichotomy and Monetary Neutrality 667 Velocity and the Quantity Equation 668 Case Study: Money and Prices during Four Hyperinflations 670 The Inflation Tax 671 In the News: The German Hyperinflation 672 The Fisher Effect 673 The Costs of Inflation 675 A Fall in Purchasing Power? The Inflation Fallacy 676 Shoeleather Costs 676 Menu Costs 677 Relative-Price Variability and the Misallocation of Resources 678 Inflation-Induced Tax Distortions 678 Confusion and Inconvenience 680 A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth 680 Case Study: The Wizard of Oz and the Free-Silver Debate 681 In the News: How to Protect Your Savings from Inflation 682 Conclusion 684 Summary 685 Key Concepts 685 Questions for Review 685 Problems and Applications 686 The Macroeconomics of Open Economies 689 Open-Economy Macroeconomics: Basic Concepts 691 The International Flows of Goods and Capital 692 The Flow of Goods: Exports, Imports, and Net Exports 692 Case Study: The Increasing Openness of the U.S. Economy 693 The Flow of Financial Resources: Net Capital Outflow 694 The Equality of Net Exports and Net Capital Outflow 695 Saving, Investment, and Their Relationship to the International Flows 696 In the News: Americans Rely on Capital Flows from Abroad 697 Summing Up 698 Case Study: Is the U.S. Trade Deficit a National Problem? 699 The Prices for International Transactions: Real and Nominal Exchange Rates 701 Nominal Exchange Rates 701 Real Exchange Rates 702 FYI: The Euro 703 A First Theory of Exchange-Rate Determination: Purchasing-Power Parity 704 The Basic Logic of Purchasing-Power Parity 705 Implications of Purchasing-Power Parity 705 Case Study: The Nominal Exchange Rate during a Hyperinflation 707 In the News: The Starbucks Index 708 Limitations of Purchasing-Power Parity 708 Case Study: The Hamburger Standard 710 Conclusion 711 Summary 711 Key Concepts 711 Questions for Review 712 Problems and Applications 712 A Macroeconomic Theory of the Open Economy 715 Supply and Demand for Loanable Funds and for Foreign-Currency Exchange 716 The Market for Loanable Funds 716 The Market for Foreign-Currency Exchange 718 FYI: Purchasing-Power Parity as a Special Case 720 Equilibrium in the Open Economy 720 Net Capital Outflow: The Link between the Two Markets 720 Simultaneous Equilibrium in Two Markets 721 FYI: Disentangling Supply and Demand 723 How Policies and Events Affect an Open Economy 724 Government Budget Deficits 724 In the News: The U.S. Trade Deficit 726 Trade Policy 727 Political Instability and Capital Flight 729 Case Study: Could Capital Flee from the United States? 731 Conclusion 732 Summary 733 Key Concepts 733 Questions for Review 734 Problems and Application 734 Short-Run Economic Fluctuations 737 Aggregate Demand and Aggregate Supply 739 Three Key Facts about Economic Fluctuations 740 Economic Fluctuations Are Irregular and Unpredictable 740 Most Macroeconomic Quantities Fluctuate Together 740 As Output Falls, Unemployment Rises 742 Explaining Short-Run Economic Fluctuations 742 The Assumptions of Classical Economics 742 In the News: Offbeat Indicators 743 The Reality of Short-Run Fluctuations 744 The Model of Aggregate Demand and Aggregate Supply 744 The Aggregate-Demand Curve 746 Why the Aggregate-Demand Curve Slopes Downward 746 Why the Aggregate-Demand Curve Might Shift 749 The Aggregate-Supply Curve 750 Why the Aggregate-Supply Curve Is Vertical in the Long Run 751 Why the Long-Run Aggregate-Supply Curve Might Shift 752 Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation 754 Why the Aggregate-Supply Curve Slopes Upward in the Short Run 755 Why the Short-Run Aggregate-Supply Curve Might Shift 758 Two Causes of Economic Fluctuations 760 The Effects of a Shift in Aggregate Demand 761 FYI: Monetary Neutrality Revisited 763 Case Study: Two Big Shifts in Aggregate Demand: The Great Depression and World War II 764 Case Study: The Recession of 2001 765 FYI: The Origins of Aggregate Demand and Aggregate Supply 766 The Effects of a Shift in Aggregate Supply 767 Case Study: Oil and the Economy 769 FYI: The Macroeconomic Impact of Hurricane Katrina 770 Conclusion 771 Summary 771 Key Concepts 772 Questions for Review 772 Problems and Applications 773 The Influence of Monetary and Fiscal Policy on Aggregate Demand 777 How Monetary Policy Influences Aggregate Demand 778 The Theory of Liquidity Preference 779 The Downward Slope of the Aggregate-Demand Curve 781 FYI: Interest Rates in the Long Run and the Short Run 782 Changes in the Money Supply 784 The Role of Interest-Rate Targets in Fed Policy 785 Case Study: Why the Fed Watches the Stock Market (and Vice Versa) 786 How Fiscal Policy Influences Aggregate Demand 787 Changes in Government Purchases 787 The Multiplier Effect 787 A Formula for the Spending Multiplier 788 Other Applicati