Macro 1

MACROECONOMICS

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MICHAEL PARKIN

M

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DOUGLAS McTAGGART CHRISTOPHER FINDLAY MICHAEL PARKIN

MACROECONOMICSSEVENTH EDITION

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National Library of AustraliaCataloguing-in-Publication Data

Author: McTaggart, Douglas, 1953-Title: Macroeconomics / Douglas McTaggart, Christopher Findlay, Michael Parkin.Edition: 7th ed.ISBN: 9781442550797 (pbk.) Notes: Includes index. Subjects: Macroeconomics Textbooks.Other Authors/Contributors: Findlay, Christopher C. (Christopher Charles), Parkin, Michael, 1939-.Dewey Number: 339

Every effort has been made to trace and acknowledge copyright. However, should any infringement have occurred, the publishers tender their apologies and invite copyright owners to contact them.

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Doug McTaggart is recently retired as Chief Executive Officer of theQueensland Investment Corporation (a fund manager with over $65 billion in assets undermanagement). He was a student at the Australian National University, earned his PhD atthe University of Chicago, and has held academic appointments at the Virginia PolytechnicInstitute, the University of Adelaide and Bond University. He is a former Under Treasurerand Under Secretary of the Queensland Treasury, a past President of the Economic Societyof Australia, a former member of the Australian Accounting Standards Board, and a formerChairman of the Investment and Financial Services Association (now Financial ServicesCouncil). Currently he is a Councillor on the National Competition Council and the CoagReform Council. He is also a director on a number of listed and unlisted companies.Dr McTaggarts research and publications spanned a wide area and covermacroeconomics, monetary theory, game theory and applied microeconomics.

Christopher Findlay was educated at the University of Adelaide and theAustralian National University (ANU). He was Professor of Economics in the Asia PacificSchool of Economics and Government at the ANU before moving in late 2005 to theUniversity of Adelaide to become Professor of Economics and Head of the School ofEconomics. He is now Executive Dean of the University of Adelaide Faculty of theProfessions. His chief interests are Australias economic links with Asia and internationaltrade and investment in services, air transport in particular.

Michael Parkin received his training as an economist at the Universities ofLeicester and Essex in England. He is Professor Emeritus in the Department of Economics atthe University of Western Ontario, Canada. Professor Parkin has held faculty appointmentsat Brown University, the University of Manchester, the University of Essex and BondUniversity. He is a past president and fellow of the Canadian Economics Association andhas served on the editorial boards of the American Economic Review and the Journal ofMonetary Economics and as managing editor of the Canadian Journal of Economics.Professor Parkins research on macroeconomics, monetary economics and internationaleconomics has resulted in over 160 publications in journals and edited volumes, includingthe American Economic Review, the Journal of Political Economy, the Review of EconomicStudies, the Journal of Monetary Economics, and the Journal of Money, Credit andBanking. He became most visible to the public with his work on inflation that discredited theuse of wage and price controls. Michael Parkin also spearheaded the movement towardsEuropean monetary union.

ABOUT THE AUTHORS

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Dedications

Douglas McTaggart dedicates this book to Pam, Cameron, Lachlan and especially Andrew.

Christopher Findlay dedicates this book to Tania, Marek and Kasia.

Michael Parkin dedicates this book to all his students.

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ix

PART ONEINTRODUCTION 1CHAPTER 1 What Is Economics? 1CHAPTER 2 The Economic Problem 29CHAPTER 3 Demand and Supply 51

PART FOUR MONITORING MACROECONOMICPERFORMANCE 397CHAPTER 18 Measuring GDP and Economic

Growth 397CHAPTER 19 Monitoring Jobs and Inflation 421

PART FIVE UNDERSTANDING THE MACROECONOMY 443CHAPTER 20 Economic Growth 443CHAPTER 21 Finance, Saving and Investment 469CHAPTER 22 Money, the Price Level and Inflation

493CHAPTER 23 The Exchange Rate and the Balance of

Payments 519CHAPTER 24 Aggregate Supply and Aggregate

Demand 545CHAPTER 25 Expenditure Multipliers: The Keynesian

Model 569CHAPTER 26 Australian Macroeconomic

Fluctuations 599

PART SIX MACROECONOMIC POLICY 621CHAPTER 27 Fiscal Policy 621CHAPTER 28 Monetary Policy 645

BRIEF CONTENTS

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The future is always uncertain. But at some times,and now is one such time, the range of possiblefutures is enormous. As a small economy tightlyintegrated into the global economy, it is uncertaintyabout external forces that dominates Australiasoutlook.There is uncertainty about monetary policy with

the European Central bank and the U.S. FederalReserve Bank holding interest rates at historical lowsand injecting billions of dollars of money in anattempt to stimulate a flagging recovery from a globalfinancial crisis. And there is extraordinary uncertaintyabout fiscal policy as budget deficits in the UnitedStates and Europe seem ever harder to control.Whether or when economic growth in China and

India will slow and dampen the growth of the rest ofthe world is a big unknown.Since the global financial crisis of August 2007

moved economics from the business page of the news-paper to the front page, fear has gripped producers,consumers, financial institutions and governments.Even the idea that the market is an efficient mecha-

nism for allocating scarce resources came into ques-tion as some political leaders trumpeted the end ofcapitalism and the dawn of a new economic order inwhich tighter regulation reined in unfettered greed.Rarely do teachers of economics have such a rich

feast on which to draw. And rarely are the principlesof economics more surely needed to provide the solidfoundation on which to think about economic eventsand navigate the turbulence of economic life.Although thinking like an economist can bring a

clearer perspective to and a deeper understanding oftodays events, students dont find the economic wayof thinking easy or natural. Economics seeks to putclarity and understanding in the grasp of the studentthrough its careful and vivid exploration of thetension between self-interest and the social interest,the role and power of incentives of opportunity costand marginal benefit and the possibility thatmarkets supplemented by other mechanisms mightallocate resources efficiently.McTaggart, Findlay and Parkin students begin to

think about issues the way real economists do andlearn how to explore difficult policy problems andmake more informed decisions in their own lives.

The Seventh Edition RevisionSimpler where possible, stripped of some technicaldetail, more copiously illustrated with well-chosenphotographs, reinforced with improved chapter sum-maries and problem sets, and even more tightly inte-grated with MyEconLab: These are the hallmarks ofthis seventh edition of Economics.This comprehensive revision also incorporates and

responds to the detailed suggestions for improve-ments made by reviewers and users, both in the broadarchitecture of the text and in each chapter. The revi-sion builds on the improvements achieved in previ-ous editions and retains its thorough and detailedpresentation of the principles of economics, itsemphasis on real-world examples and applications, itsdevelopment of critical thinking skills, its diagramsrenowned for pedagogy and precision and its path-breaking technology.Most chapters have been fine-tuned to achieve

even greater clarity and to present the material in amore straightforward, visual and intuitive way.Some chapters have been thoroughly reworked tocover new issues, particularly those that involve current policy problems. These changes are aimed atbetter enabling students to learn how to use the economic toolkit to analyse their own decisions andunderstand the events and issues they are confrontedwith in the media and at the ballot box.Current issues organise each chapter. News stories

about todays major economic events tie a chaptertogether, from new, briefer chapter-opening questionsto end-of-chapter problems and online practice. Eachchapter includes a discussion of a critical issue of ourtime to demonstrate how economic theory can beapplied to explore a particular debate or question. Among the many issues covered are

The rising cost of food in Chapter 2 The fluctuating price of bananas and coffee inChapter 3

Recession and unemployment in Chapters 18, 24and 26

Currency fluctuations and the managed Chineseyuan in Chapter 23

PREFACE

xi

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Fiscal stimulus and the debate about the fiscalstimulus multipliers in Chapter 27

Monetary stimulus in Chapter 28.

Real-world examples and applications appear in the body of each chapter and in the end-of-chapterproblems and applications, which are available inMyEconLab for assignment as homework, quizzes ortests.A selection of the questions that appear weekly in

MyEconLab in Economics in the News is also availablefor assignment as homework, quizzes or tests.

Highpoints of the RevisionAll the chapters have been updated to incorporatedata to the second quarter of 2011 and the news andpolicy situation to the second quarter of 2012. And inaddition to being thoroughly updated and revised toinclude the topics and features just described, thechapters feature the following nine notable changes:1. What Is Economics? (Chapter 1): We have re -worked the explanation of the economic way of thinking around six key ideas, all illustrated with student-relevant choices. The graphing appendix tothis chapter has an increased focus on scatter diagramsand their interpretation and on understanding shiftsof curves.2. Measuring GDP and Economic Growth(Chapter 18): We have revised the section on cross-country comparisons and the limitations of GDP tomake the material clearer and we have added photoillustrations of purchasing power parity and of itemsomitted from GDP. A new appendix to this chapterexplains the graphing of time-series data and the useof a ratio scale to reveal trends. The MathematicalNote on chain volume measure of GDP has been simplified.3. Monitoring Jobs and Inflation (Chapter 19): Thischapter now includes a discussion and illustration ofthe duration of unemployment spells. We have rewrit-ten the section on full employment and the influenceson the natural unemployment rate. The coverage ofthe price level has been expanded to define andexplain the costs of deflation as well as inflation.

4. Economic Growth (Chapter 20): We have simpli-fied this chapter by omitting the technical details ongrowth accounting and replacing them with an intu-itive discussion of the crucial role of human capitaland intellectual property rights. We illustrate the roleplayed by these key factors during Britains IndustrialRevolution. We have made the chapter more relevantand empirical by including a summary of the correla-tions between the growth rate and the positive andnegative influences on it. 5. Money, the Price Level and Inflation (Chapter 22):This chapter compares the Reserve Banks response tothe global financial crisis with the U.S. FederalReserves extraordinary injection of monetary base fol-lowing the financial panic of 2008.We have redrawnthe line between this chapter, the money andbanking chapter, and the later monetary policychapter by including in this chapter a complete expla-nation of how an open market operation works. Wehave also provided clearer and more thorough expla-nations of the money multiplier and money marketequilibrium in the short and the long run and in thetransition to the long run.6. The Exchange Rate and the Balance of Payments(Chapter 23): We have revised this chapter to betterexplain the distinction between the fundamentals andthe role of expectations. We have also included anexplanation of how arbitrage works in the foreignexchange market and the temporary and risky natureof seeking to profit from the so-called carry trade.7. Aggregate Supply and Aggregate Demand(Chapter 24): We have revised the section of thischapter that explains the use of the AS-AD model tounderstand growth and inflation trends and businesscycle fluctuations. We have closely tied these explana-tions to the Australian data on economic growth,inflation and the business cycle with an emphasis onthe most recent business cycle.8. Fiscal Policy (Chapter 27): The topic of thischapter is front-page news almost every day and islikely to remain so. The revision describes the budgetdeficit and debt and explains the consequences of theuncertainty they engender. A thoroughly revisedsection examines the fiscal stimulus measures takenover the past year, channels through which the stimu-

xii PREFACE

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PREFACE xiii

lus works, the unwanted side effects of the stimulus,its potentially limited power and its short comings.The chapter also examines the controversy about andrange of views on the size of the fiscal stimulus multi-plier.9. Monetary Policy (Chapter 28): This chapterdescribes and explains the monetary policy responsesto the 20082009 recession and the persistent head-winds of 2010 and 2011. It also contains an improveddescription of the Reserve Banks decision-makingprocess. Technical details about alternative monetarypolicy strategies have been replaced with a shorter andmore focused discussion of this topic and the need tobring clarity and predictability to monetary policy to anchor inflation expectations.

Features to Enhance Teachingand Learning

Reading Between the LinesThis McTaggart, Findlay and Parkin hallmark helpsstudents think like economists by connecting chaptertools and concepts to the world around them. InReading Between the Lines at the end of each chapterstudents apply the tools they have just learned byanalysing an article from a newspaper or news website. Each article sheds additional light on thequestions first raised in the chapter opener.Questions about the article also appear with the

end-of-chapter problems and applications.

Coffee Surges on Poor Colombian HarvestsFT.com30 July 2010

Coffee prices hit a 12-year high on Friday on the back of low supplies of premium Arabicacoffee from Colombia after a string of poor crops in the Latin American country.

The strong fundamental picture has also encouraged hedge funds to reverse their previousbearish views on coffee prices.

In New York, Arabica coffee jumped 3.2 per cent to 178.75 cents per pound, the highestsince February 1998. It traded later at 177.25 cents, up 6.8 per cent on the week.

The London-based International Coffee Organization on Friday warned that the currenttight demand and supply situation was likely to persist in the near to medium term.

Coffee industry executives believe prices could rise towards 200 cents per pound in New Yorkbefore the arrival of the new Brazilian crop laterthis year.

Until October it is going to be tight on highquality coffee, said a senior executive at one ofEuropes largest coffee roasters. He said: Theindustry has been surprised by the scarcity ofhigh quality beans.

Colombian coffee production, key for suppliesof premium beans, last year plunged to a33-year low of 7.8 m bags, each of 60 kg, downnearly a third from 11.1 m bags in 2008, tight -ening supplies worldwide

Excerpted from Coffee Surges on Poor Colombian Harvests by JavierBlas, Financial Times. The Financial Times Limited (2010). All rights reserved.

READING BETWEEN THE L INES

Demand and Supply: The Price of Coffee

The price of premium Arabica coffee increasedby 3.2 per cent to almost 180 cents per pound inJuly 2010, the highest price since February1998.

A sequence of poor crops in Colombia cut theproduction of premium Arabica coffee to a33-year low of 7.8 million 60 kilogram bags,down from 11.1 million bags in 2008.

The International Coffee Organization said thatthe current tight demand and supply situationwas likely to persist in the near to medium term.

Coffee industry executives say prices might approach 200 cents per pound before the arrivalof the new Brazilian crop later this year.

Hedge funds previously expected the price of coffee to fall but now expect it to rise further.

ESSENCE OF THE STORY

Figure 2 The Effects of the Expected Future Price

D

S1

S0

Figure 1 The Effects of the Colombian Crop

Decrease inColombian crop ...

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Rise in expected futureprice increases demandand decreases supply ...

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170

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... and raisesprice further

D0

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ECONOMIC ANALYSIS

This news article reports two sources of changes insupply and demand that changed the price of coffee.

The first source of change is the sequence of poorharvests in Colombia. These events decreased theworld supply of Arabica coffee. (Arabica is the typethat Starbucks uses.)

Before the reported events, the world production ofArabica was 120 million bags per year and its pricewas 174 cents per pound.

The decrease in the Colombian harvest decreasedworld production to about 116 million bags, which isabout 3 per cent of world production.

Figure 1 shows the situation before the poorColombian harvests and the effects of those poorharvests. The demand curve is D and initially thesupply curve was S0. The market equilibrium is at120 million bags per year and a price of 174 centsper pound.

The poor Colombian harvests decreased supply andthe supply curve shifted leftward to S1. The priceincreased to 180 cents per pound and the quantitydecreased to 116 million bags.

The second source of change influenced both supplyand demand. It is a change in the expected futureprice of coffee.

The hedge funds referred to in the news article arespeculators that try to profit from buying at a low priceand selling at a high price.

With the supply of coffee expected to remain low, theprice was expected to rise further a rise in theexpected future price of coffee.

When the expected future price of coffee rises, somepeople want to buy more coffee (so they can sell itlater) an increase in the demand today. And somepeople offer less coffee for sale (so they can sell it laterfor a higher price) a decrease in the supply today.

Figure 2 shows the effects of these changes in the demand and supply today.

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Graphs That Show the ActionThrough the past six editions, this book has set newstandards of clarity in its graphs; the seventh editioncontinues to uphold this tradition. Our goal hasalways been to show where the economic action is.Our graphs continue to generate an enormously positive response, which confirms our view thatgraphical analysis is the most powerful tool availablefor teaching and learning economics.Because many students find graphs hard to work

with, we have developed the entire art program withthe study and review needs of the student in mind.The graphs feature

Original curves consistently shown in blue Shifted curves, equilibrium points and otherimportant features highlighted in red

Colour-blended arrows to suggest movement Graphs paired with data tables Graphs labelled with boxed notes Extended captions that make each graph and itscaption a self-contained object for study andreview.

Chapter ObjectivesEach chapter begins with a list of learning objectives,which enables students to see exactly where thechapter is going and to set their goals before theyembark on their detailed study.

Chapter OpenersEach chapter opens with a carefully chosen photo-graph, question and student-friendly vignettedesigned to give students a quick sense of what thechapter is about and how it connects with their owneconomic world and experience. The chapter openingstory is woven into the body of the chapter andexplored further in the Reading Between the Linesfeature that ends the chapter.

Economics in Action BoxesThis new feature addresses current events and eco-nomic occurrences that highlight and amplify thetopics covered in the chapter. Instead of simplyreporting the current events, the material applies theevent to an economics lesson, enabling students to seehow economics plays a part in the world around themas they read through the chapter.Some of the many issues covered in this feature

include the global market for crude oil, the best afford-able choice of movies and DVDs, the cost of selling apair of shoes, how Apple doesnt make the iPhone, thetrends and cycles in real GDP and the price level, andthe size of the fiscal stimulus multipliers.

xiv PREFACE

Quantity

P

Decrease in supply

Increase in supply

0

Decrease inquantitysupplied

Increase inquantitysupplied

S2 S0 S1

6

Economics in ActionThe Global Market for Crude OilThe demand and supply model provides insights intoall competitive markets. Here, well apply what youvelearned about the effects of an increase in demand tothe global market for crude oil.

Crude oil is like the life-blood of the globaleconomy. It is used to fuel our cars, aeroplanes, trainsand buses, to generate electricity and to produce awide range of plastics. When the price of crude oilrises, the costs of transportation, power and materialsall increase.

In 2001, the price of a barrel of oil was $20 (usingthe value of money in 2010). In 2008, before theglobal financial crisis ended a long period of eco-nomic expansion, the price peaked at $127 a barrel.

While the price of oil was rising, the quantity ofoil produced and consumed also increased. In 2001,the world produced 65 million barrels of oil a day. By2008, that quantity was 72 million barrels.

Who or what has been raising the price of oil? Is itthe action of greedy oil producers? Oil producersmight be greedy and some of them might be bigenough to withhold supply and raise the price, but itwouldnt be in their self-interest to do so. The higherprice would bring forth a greater quantity suppliedfrom other producers and the profit of the producerlimiting supply would fall.

Oil producers could try to cooperate and jointlywithhold supply. The Organisation of PetroleumExporting Countries, OPEC, is such a group of pro-ducers. But OPEC doesnt control the world supplyand its members self-interest is to produce the quanti-ties that give them the maximum attainable profit.

So even though the global oil market has some bigplayers, they dont fix the price. Instead, the actionsof thousands of buyers and sellers and the forces ofdemand and supply determine the price of oil.

So how have demand and supply changed?Because both the price and the quantity have

increased, the demand for oil must have increased.Supply might have changed too, but here wellsuppose that supply has remained the same.

The global demand for oil has increased for onemajor reason: World income has increased. Theincrease has been particularly large in the emergingeconomies of China, India and Brazil. Increasedworld income has increased the demand for oil-usinggoods such as electricity, petrol and plastics, which inturn has increased the demand for oil.

The figure illustrates the effects of the increase indemand on the global oil market. The supply of oilremained constant along supply curve S. The demandfor oil in 2001 was D2001, so in 2001 the price was$20 a barrel and the quantity was 65 million barrelsper day. The demand for oil increased and by 2008 ithad reached D2008. The price of oil increased to $127 abarrel and the quantity increased to 72 million barrelsa day. The increase in the quantity is an increase in thequantity supplied, not an increase in supply.

200

60 72 85

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Quantity (millions of barrels per day)65

127

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Rise in globalincomes increasesthe demand for oil

The Global Market for Crude Oil

Price ofoil rises ...

and quantityof oil suppliedincreases

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PREFACE xv

Key TermsHighlighted terms simplify the students task of learn-ing the vocabulary of economics. Each highlightedterm appears in an end-of-chapter list with its pagenumber, in an end-of-book glossary with its pagenumber, bold-faced in the index, and in MyEconLabin the interactive glossary and flashcards.

End-of-Chapter SummaryEach chapter closes with a concise summary organisedby major topics and list of key terms with page refer-ences. These learning tools provide students with asummary for review and exam preparation.

In-Text Review Quizzes and End-of-ChapterProblems and ApplicationsA Review Quiz at the end of each major sectionenables students to determine whether a topic needsfurther study before moving on, and Problems andApplications at the end of each chapter provide anopportunity to practise and apply the topics of thechapter.All the Review Quizzes and end-of-chapter

Problems and Applications are in the MyEconLabStudy Plan (see p. xvi) where students can work themand receive instant feedback and explanations.

For the LecturerThis book enables you to focus on the economic wayof thinking and choose your own course structure.

Focus on the Economic Way of ThinkingAs a teacher, you know how hard it is to encourage astudent to think like an economist. But that is yourgoal. Consistent with this goal, the text focuses on andrepeatedly uses the central ideas: choice; tradeoff;opportunity cost; the margin; incentives; the gainsfrom voluntary exchange; the forces of demand,supply and equilibrium; the pursuit of economic rent;the tension between self-interest and the social inter-est; and the scope and limitations of governmentactions.

Flexible StructureYou have preferences for how you want to teach yourcourse. We have organised this book to enable you todo so. The flexibility chart on p. xix illustrate the

books flexibility. By following the arrows through thecharts you can select the path that best fits your pref-erence for course structure. Whether you want toteach a traditional course that blends theory andpolicy, or one that takes a fast track through eithertheory or policy issues, Economics gives you thechoice.

Supplemental ResourcesAll instructor supplements are available via: the Pearson catalogue page(www.pearson.com.au/9781442550773)

MyEconLab (www.pearson.com.au/mctaggart)

Computerised Test Banks The seventh edition testbank (Test Item File) with more than 3,000 multiple-choice questions has been prepared by Mark Dodd ofthe University of Adelaide and Tikiri Agalewatte of theUniversity of Wollongong. Mark and Tikiri reviewedall existing questions to ensure their clarity and consis-tency with the seventh edition. New questions followthe style and format of the end-of-chapter text prob-lems and they provide the lecturer with a new set oftesting opportunities and/or homework assignments.Test Item File questions are available in MyEconLabfor instructors to use in a test, a quiz or as homework.Pearsons TestGen enables instructors to view and

edit test bank questions, generate tests, and printthem in a variety of formats. Search and sort functionsmake it easy to locate questions and arrange them inany order desired. TestGen also enables instructors toadminister tests on a local area network, have testsgraded electronically, and have the results prepared inelectronic or printed reports.Pearson TestGen is compatible with Windows or

Macintosh systems.

Solutions Manual For ease of use and instructor refer-ence, a comprehensive Solutions Manual provides lecturers with detailed solutions to the ReviewQuizzes and the end-of-chapter Study Plan Problemsand Applications and Additional Problems andApplications. John Snelling of the University ofAdelaide has prepared the Solutions Manual. For anelectronic version of the Solutions Manual go towww.pearson.com.au/9781442550773.

PowerPoint Resources Robin Bade has developed thefull-colour Microsoft PowerPoint Lecture Presen -tation for each chapter, which includes animated

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versions of the textbook figures, tables from the text-book and speaking notes.A separate set of PowerPoint files containing large-

scale animated versions of all the textbooks figuresand the tables from the text is available. Use the presentations electronically in the classroom orprinted to create hard-copy transparency masters.This item is available for Macintosh and Windows.

Instructors Resource Centre Lecturers can downloadsupplements from a secure, instructor-only source atwww.pearson.com.au/9781442550773.

MyEconLab MyEconLabMyEconLabs assessment and tutorial system workshand-in-hand with Economics. With comprehensivehomework, quiz, test and tutorial options, lecturerscan manage all assessment needs in one program. All of the Review Quiz questions and end-of-chapter Problems and Applications are assignableand automatically graded.

Students can work the Review Quiz questionsand end-of-chapter Study Plan Problems andApplications as part of the MyEconLab Study Plan.

Instructors can assign the end-of-chapterAdditional Problems and Applications asautograded assignments. These Problems andApplications are not available to students inMyEconLab unless assigned by the instructor.

Many of the Problems and Applications arealgorithmic, draw-graph and numerical exercises.

Test Item File questions are available forassignment as homework.

The Custom Exercise Builder gives instructors theflexibility of creating their own problems forassignment.

The Gradebook records each studentsperformance and the time spent on Tests, StudyPlan and Homework and generates reports bystudent or by chapter.

Economics in the News is a turn-key solution tobringing daily news into the classroom. Updatedweekly during the academic year, we upload tworelevant articles (one micro, one macro) andprovide links for further information andquestions that may be assigned for homework orfor classroom discussion.

A suite of ABC News (U.S.) videos, which addresscurrent topics such as education, energy, U.S.Federal Reserve policy and business cycles, isavailable for classroom use. Video-specific exercisesare available for instructor assignment. Michael Parkin and Robin Bade, assisted by

Jeannie Gillmore and Laurel Davies, author andoversee all of the MyEconLab content for Economics.Our peerless MyEconLab team has worked hard toensure that it is tightly integrated with the bookscontent and vision. For more information go towww.pearson.com.au/mctaggart.

Experiments in MyEconLabExperiments are a fun and engaging way to promoteactive learning and mastery of important economicconcepts. Pearsons experiments program is flexibleand easy for lecturers and students to use. Single-player experiments allow your students toplay against virtual players from anywhere at any time with an Internet connection.

Multiplayer experiments allow you to assign andmanage a real-time experiment with your class.

Pre- and post-questions for each experiment areavailable for assignment in MyEconLab.

For the StudentWith this textbook, you get access to some powerfullearning tools.

MyEconLab MyEconLabMyEconLabs tutorial system provides lots of opportu-nities to practise and review what you are learning.

Take a Sample Test to create your personalisedStudy Plan.

Work the Review Quiz questions and end-of-chapter Study Plan Problems and Applicationsin your MyEconLab Study Plan and get instant feedback.

Use the Help Me Solve This problem tools whenyou need extra help.

xvi PREFACE

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PREFACE xvii

Use the Pearson e-text version of your textbook tosearch, make notes, view animated versions of thetextbook figures and check a definition in the electronic glossary.

Use the Ask the Authors tool to send an email tothe authors and get help when you need it.

Registering for MyEconLab with an access card Ifyour textbook came bundled with a MyEconLabaccess code, refer to the card for registration instruc-tions.

Purchasing access If your textbook did not comebundled with a MyEconLab access code, you can purchase an access code at www.pearson.com.au/mctaggart.

Study on the GoAt the end of each chapter, you will find a unique QRcode providing access to Study on the Go, an unprece-dented mobile integration between text and onlinecontent. You can link to Pearsons unique Study onthe Go content directly from your smartphone, allow-ing you to study whenever and wherever you wish! Goto one of the sites below to see how you can downloadan app to your smartphone for free. Once the app isinstalled, scan the code and your phone will link to awebsite containing Pearsons Study on the Go content,including the popular study tools: glossary, flashcards,audio summaries and multiple-choice quizzes, whichcan be accessed at any time.ScanLife: http://get.scanlife.comNeoReader: http://get.neoreader.comQuickMark: http://www.quickmark.com.tw

PowerPoint Lecture NotesRobin Bade has developed the full-colour MicrosoftPowerPoint Lecture Notes for each chapter, whichinclude animated versions of the textbook figures.Take these notes to class and edit them to create yourown personal summary for review.

VitalSource EditionVitalSource is an electronic version of the text to fityour mobile lifestyle. Download it to your computerand search for key concepts, words and phrases, makehighlights and notes as you study and share your noteswith your friends.

AcknowledgementsAs we said in earlier editions, one of the great pleas-ures of writing an introductory text is the opportunityit affords to learn from so many generous friends andcolleagues. Although the extent of our debt cannot befully acknowledged here, it is nevertheless a joy torecord our gratitude to the many people who havehelped, some without realising just how helpful theyhave been.We thank our many exceptional reviewers whose

names are listed on the following pages. Many ofthem spent much more time than we could have reasonably expected and provided detailed commentson drafts of the manuscript. Their comments and suggestions have been extremely helpful and we havemade every attempt to heed their advice.We thank the several thousand students whom we

have been privileged to teach. The instant responsethat comes from the look of puzzlement or enlighten-ment has taught us how to teach economics.We also thank Doon-Louise Williams and David

Tucker, students at Griffith University, for pointingout an error in the sixth edition.We thank Richard Parkin for his work on the elec-

tronic art manuscript, the PowerPoint animations andthe Flash animations of the figures in the e-text onMyEconLab. We thank Jeannie Gillmore and LaurelDavies for creating and managing our evergrowingand ever more complex MyEconLab database. We alsothank John Snelling of the University of Adelaide forhelping with news-based end-of-chapter problemsand applications.Finally, we are deeply grateful to the editorial team

at Pearson Australia. Vision, energy, enthusiasm, pro-fessionalism, flair and commitment are just some ofthe characteristics of the team. Editor in Chief FrancesEden, Manager Product Development MichaelStone, Senior Acquisitions Editor Simone Bella, SeniorProject Editor Rebecca Pomponio and EditorialCoordinator Germaine Silva have again confirmedwith this new edition their reputation as Australiasfinest academic publishers. They have built a culturethat brings out the best in their editors and authors.They have been supported by Copyright and

Pictures Editor Lisa Woodland, copy editor FelicityMcKenzie, proofreader Nicole Le Grand and typeset-ter Leonie Ryan. We are grateful for their commitmentto the project and their excellent attention to detail.

Prelims MACRO Aus 7e_ECO Prelims 7e 14/06/12 2:53 PM Page xvii

Classroom experience will test the value of thisbook. We would appreciate hearing from instructorsand students about how we can continue to improve itin future editions.

Douglas McTaggartQueensland Investment Corporationemail: [email protected]

Christopher FindlayUniversity of Adelaideemail: [email protected]

Michael ParkinUniversity of Western Ontarioemail: [email protected]

Reviewers of the Seventh EditionRod Duncan, Charles Sturt UniversityRichard Dutu, Deakin UniversityCatherine Fletcher, Monash UniversityPeter Harkness, Swinburne UniversityYolanta Kwiecien, Monash UniversityPaul Morris, University of NewcastleMunirul Nabin, Deakin UniversityPeter Schuwalow, Monash UniversityZulfan Tadjoeddin, University of Western Sydney

Reviewers of the Sixth EditionJayanath Ananda, La Trobe UniversitySiobhan Austen, Curtin Business SchoolCarol Barry, Swinburne University of TechnologyJohn Bevacqua, Charles Sturt University

Jonathan Boymal, Royal Melbourne Institute ofTechnology

Mark Buchanek, Deakin UniversityBob Catley, University of NewcastleBronwyn Coate, Royal Melbourne Institute ofTechnology

Maxine Darnell, University of New EnglandSinclair Davidson, Royal Melbourne Institute ofTechnology

Catherine Fletcher, Monash University Gigi Foster, University of South AustraliaChris Gellar, Deakin UniversityMary Graham, Deakin UniversityBranka Krivokapic-Skoko, Charles Sturt UniversityYun-Lok Lee, Southern Cross UniversityElizabeth Manning, Deakin UniversityAnn Marsden, University of TasmaniaStephen Mason, Southern Cross UniversityPundarik Mukhopadhaya, Macquarie UniversityMuni Perumal, University of CanberraElla Reeks, University of TasmaniaJohn Rice, University of AdelaideGraham Richards, Trinity College, University of Melbourne

Sveta Risman, Royal Melbourne Institute ofTechnology

Ali Saleh, University of WollongongPasquale Sgro, Deakin UniversityBaljit Singh, La Trobe UniversityHazbo Skoko, Charles Sturt UniversitySam Tang, University of Western AustraliaMehmet Ulubasoglu, Deakin UniversitySpiro George Vlachos, University of AdelaideMark Weder, University of Adelaide

xviii PREFACE

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Chapter 19

Monitoring Jobsand Inflation

Chapter 18

Measuring GDP andEconomic Growth

Chapter 24

Aggregate Supply andAggregate Demand

Chapter 22

Money, the Price Leveland Inflation

Chapter 23

The Exchange Rate andthe Balance of Payments

Chapter 25

Expenditure Multipliers:The Keynesian Model

Chapter 21

Finance, Savingand Investment

Chapter 20

Economic Growth

Chapter 26

AustralianMacroeconomic

Fluctuations

Chapter 27

Fiscal Policy

Chapter 28

Monetary Policy

Macro Flexibility

Start here ... then jump toany of these

and jump to any of these afterdoing the prerequisites indicated

Chapter 1

What Is Economics?

Chapter 2

The Economic Problem

Chapter 3

Demand and Supply

xix

ALTERNATIVE PATHWAYS THROUGH THE MACRO CHAPTERS

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PART ONEINTRODUCTION 1

CHAPTER 1 WHAT IS ECONOMICS? 1

Definition of Economics 2

Two Big Economic Questions 3What, How and for Whom? 3Can the Pursuit of Self-Interest Promote the Social Interest? 5

The Economic Way of Thinking 8A Choice Is a Tradeoff 8Making a Rational Choice 8Benefit: What You Gain 8Cost: What You Must Give Up 8How Much? Choosing at the Margin 9Choices Respond to Incentives 9

Economics as Social Science and Policy Tool 10Economist as Social Scientist 10Economist as Policy Adviser 10

Summary 11Study Plan Problems and Applications 12Additional Problems and Applications 12

APPENDIX Graphs in Economics 13

Graphing Data 13Scatter Diagrams 14

Graphs Used in Economic Models 16Variables That Move in the Same Direction 16Variables That Move in Opposite Directions 17Variables That Have a Maximum or a Minimum 18

Variables That Are Unrelated 19

The Slope of a Relationship 20The Slope of a Straight Line 20The Slope of a Curved Line 21

Graphing Relationships Among More Than Two Variables 22

Ceteris Paribus 22When Other Things Change 23

MATHEMATICAL NOTEEquations of Straight Lines 24A Linear Equation 24Slope of Line 24Position of Line 25Positive Relationships 25Negative Relationships 25Example 25

Summary 26Study Plan Problems and Applications 27Additional Assignable Problems and Applications 28

xxi

TABLE OF CONTENTS

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CHAPTER 2 THE ECONOMIC PROBLEM 29

Production Possibilities and Opportunity Cost 30Production Possibilities Frontier 30Production Efficiency 31Tradeoff Along the PPF 31Opportunity Cost 31

Using Resources Efficiently 33The PPF and Marginal Cost 33 Preferences and Marginal Benefit 34Allocative Efficiency 35

Economic Growth 36The Cost of Economic Growth 36A Nations Economic Growth 37

Gains from Trade 38Comparative Advantage and Absolute Advantage 38

Achieving the Gains from Trade 39

Economic Coordination 41Firms 41Markets 42Property Rights 42Money 42Circular Flows Through Markets 42Coordinating Decisions 42

READING BETWEEN THE LINESThe Rising Opportunity Cost of Food 44


CHAPTER 3 DEMAND AND SUPPLY 51

Markets and Prices 52

Demand 53The Law of Demand 53Demand Curve and Demand Schedule 53A Change in Demand 54A Change in the Quantity Demanded Versus aChange in Demand 56

Supply 58The Law of Supply 58Supply Curve and Supply Schedule 58A Change in Supply 59A Change in the Quantity Supplied Versus aChange in Supply 60

Market Equilibrium 62Price as a Regulator 62Price Adjustments 63

Predicting Changes in Price and Quantity 64An Increase in Demand 64A Decrease in Demand 64An Increase in Supply 66A Decrease in Supply 66All the Possible Changes in Demand andSupply 68

READING BETWEEN THE LINESDemand and Supply: The Price of Coffee 70

MATHEMATICAL NOTEDemand, Supply and Equilibrium 72Demand Curve 72Supply Curve 72Market Equilibrium 73An Example 73


xxii CONTENTS

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PART FOURMONITORING MACROECONOMICPERFORMANCE 397

CHAPTER 18 MEASURING GDP ANDECONOMIC GROWTH 397

Gross Domestic Product 398GDP Defined 398GDP and the Circular Flow of Expenditure and Income 399

Why Is Domestic Product Gross? 400

Measuring Australias GDP 401The Expenditure Approach 401The Income Approach 402Nominal GDP and Real GDP 403Calculating Real GDP 403

The Uses and Limitations of Real GDP 404The Standard of Living Over Time 404The Standard of Living Across Countries 406Limitations of Real GDP 407

READING BETWEEN THE LINESReal GDP Shows Slowing Economy 410

APPENDIX Graphs in Macroeconomics 412

The Time-Series Graph 412Making a Time-Series Graph 412Reading a Time-Series Graph 412Ratio Scale Reveals Trend 413A Time-Series with a Trend 413Using a Ratio Scale 413

MATHEMATICAL NOTEChain Volume Measure of Real GDP 414Value Production in Prices of Adjacent Years 414Find the Average of Two Percentage Changes 414Link (Chain) to the Base Year 415Exercise 415


CONTENTS xxiii

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CHAPTER 19 MONITORING JOBS ANDINFLATION 421

Employment and Unemployment 422Why Unemployment Is a Problem 422Labour Force Survey 423Three Labour Market Indicators 423Other Definitions of Underutilised Labour 425All Underutilised Labour 426

Unemployment and Full Employment 427Frictional Unemployment 427Structural Unemployment 427Cyclical Unemployment 427Natural Unemployment 428Real GDP and Unemployment Over the Cycle 428

The Changing Natural Unemployment Rate 429

The Price Level, Inflation and Deflation 430Why Inflation and Deflation Are Problems 430The Consumer Price Index 431Reading the CPI Numbers 431Constructing the CPI 431Measuring the Inflation Rate 432Distinguishing High Inflation from a High Price Level 433

The Biased CPI 433The Magnitude of the Bias 434Some Consequences of the Bias 434Alternative Price Indexes 434Core Inflation 435The Real Variables in Macroeconomics 435

READING BETWEEN THE LINESThe Australian Labour Market 436


PART FIVEUNDERSTANDING THEMACROECONOMY 443

CHAPTER 20 ECONOMIC GROWTH 443

The Basics of Economic Growth 444Calculating Growth Rates 444The Magic of Sustained Growth 444Applying the Rule of 70 445

Economic Growth Trends 446Growth in the Australian Economy 446Real GDP Growth in the World Economy 447

How Potential GDP Grows 449What Determines Potential GDP? 449What Makes Potential GDP Grow? 451

Why Labour Productivity Grows 454Preconditions for Labour Productivity Growth 454

Physical Capital Growth 455Human Capital Growth 455Technological Advances 455

Growth Theories, Evidence and Policies 457Classical Growth Theory 457Neoclassical Growth Theory 457New Growth Theory 458New Growth Theory Versus Malthusian Theory 460

Sorting Out the Theories 460The Empirical Evidence on the Causes ofEconomic Growth 460

Policies for Achieving Faster Growth 460

READING BETWEEN THE LINESProductivity and Real GDP 462


xxiv CONTENTS

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CHAPTER 21 FINANCE, SAVING ANDINVESTMENT 469

Financial Institutions and Financial Markets 470Finance and Money 470Physical Capital and Financial Capital 470Capital and Investment 470Wealth and Saving 470Financial and Capital Markets 471Financial Institutions 472Insolvency and Illiquidity 473Interest Rates and Asset Prices 474

The Loanable Funds Market 474Funds That Finance Investment 474The Real Interest Rate 475The Demand for Loanable Funds 476The Supply of Loanable Funds 477Equilibrium in the Loanable Funds Market 478Changes in Demand and Supply 478

Government in the Loanable Funds Market 481A Government Budget Surplus 481A Government Budget Deficit 481

The Global Loanable Funds Market 483International Capital Mobility 483International Borrowing and Lending 483Demand and Supply in the Global and National Markets 483

READING BETWEEN THE LINESEuro Crisis and the Global Market 486


CHAPTER 22 MONEY, THE PRICE LEVEL AND INFLATION 493

What Is Money? 494Medium of Exchange 494Unit of Account 494Store of Value 495Money in Australia Today 495

The Banking System 497Authorised Deposit-Taking Institutions 497The Reserve Bank of Australia 498The Payments System 500

How Banks Create Money 501Creating Deposits by Making Loans 501Limits to Money Creation 501The Money Creation Process 502The Money Multiplier 503

The Money Market 504The Influences on Money Holding 504The Demand for Money 505Shifts in the Demand for Money Curve 505Money Market Equilibrium 506

The Quantity Theory of Money 508

READING BETWEEN THE LINESThe Cost of Bank Regulation 510

MATHEMATICAL NOTEThe Money Multiplier 512The Australian Money Multiplier 513


CONTENTS xxv

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CHAPTER 23 THE EXCHANGE RATEAND THE BALANCE OFPAYMENTS 519

The Foreign Exchange Market 520Trading Currencies 520Exchange Rates 520Questions About the Australian Dollar Exchange Rate 520

An Exchange Rate Is a Price 520The Demand for One Money Is the Supply of Another Money 521

Demand in the Foreign Exchange Market 521Demand Curve for Australian Dollars 522Supply in the Foreign Exchange Market 523Supply Curve for Australian Dollars 523Market Equilibrium 524

Exchange Rate Fluctuations 525A Change in Demand for Australian Dollars 525A Change in Supply of Australian Dollars 526Changes in the Exchange Rate 526Fundamentals, Expectations and Arbitrage 528The Real Exchange Rate 529

Exchange Rate Policy 530Flexible Exchange Rate 530Fixed Exchange Rate 530Crawling Peg 531

Financing International Trade 533Balance of Payments Accounts 533Borrowers and Lenders 535Debtors and Creditors 535Is International Borrowing a Problem? 535Current Account Balance 536Net Exports 536Where Is the Exchange Rate? 537

READING BETWEEN THE LINESChinas Exchange Rate Policy 538


CHAPTER 24 AGGREGATE SUPPLY ANDAGGREGATE DEMAND 545

Aggregate Supply 546Quantity Supplied and Supply 546Long-Run Aggregate Supply 546Short-Run Aggregate Supply 547Changes in Aggregate Supply 548

Aggregate Demand 550The Aggregate Demand Curve 550Changes in Aggregate Demand 551

Explaining Macroeconomic Trends andFluctuations 554Short-Run Macroeconomic Equilibrium 554Long-Run Macroeconomic Equilibrium 554Economic Growth and Inflation in the

AS-AD Model 555The Business Cycle in the AS-AD Model 556Fluctuations in Aggregate Demand 558Fluctuations in Aggregate Supply 559

Macroeconomic Schools of Thought 560The Classical View 560The Keynesian View 560The Monetarist View 561The Way Ahead 561

READING BETWEEN THE LINESAggregate Supply and Aggregate Demandin Action 562


xxvi CONTENTS

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CHAPTER 25 EXPENDITURE MULTIPLIERS:THE KEYNESIAN MODEL 569

Fixed Prices and Expenditure Plans 570Expenditure Plans 570Consumption and Saving Plans 570Marginal Propensities to Consume and Save 572Slopes and Marginal Propensities 572Consumption as a Function of Real GDP 573Import Function 573

Real GDP with a Fixed Price Level 574Aggregate Planned Expenditure 574Actual Expenditure, Planned Expenditure and Real GDP 575

Equilibrium Expenditure 576Convergence to Equilibrium 577

The Multiplier 578The Basic Idea of the Multiplier 578The Multiplier Effect 578Why Is the Multiplier Greater Than 1? 579The Size of the Multiplier 579The Multiplier and the Slope of the

AE Curve 580Imports and Income Taxes 581The Multiplier Process 581Business Cycle Turning Points 582

The Multiplier and the Price Level 583Adjusting Quantities and Prices 583Aggregate Expenditure and Aggregate Demand 583

Deriving the Aggregate Demand Curve 583Changes in Aggregate Expenditure andAggregate Demand 584

Equilibrium Real GDP and the Price Level 585

READING BETWEEN THE LINESChanges in Expenditure Plans 588

MATHEMATICAL NOTEThe Algebra of the Keynesian Model 590Aggregate Expenditure 590Equilibrium Expenditure 591The Multiplier 591Government Expenditure Multiplier 592Autonomous Tax Multiplier 592Balanced Budget Multiplier 593


CONTENTS xxvii

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CHAPTER 26 AUSTRALIANMACROECONOMICFLUCTUATIONS 599

Inflation Cycles 600Demand-Pull Inflation 600Cost-Push Inflation 602Expected Inflation 604Forecasting Inflation 605Inflation and the Business Cycle 605

Inflation and Unemployment: The Phillips Curve 606The Short-Run Phillips Curve 606The Long-Run Phillips Curve 607Changes in the Natural Unemployment Rate 607

The Business Cycle 609Mainstream Business Cycle Theory 609Real Business Cycle Theory 610

READING BETWEEN THE LINESInflation Expectations 614


PART SIXMACROECONOMIC POLICY 621

CHAPTER 27 FISCAL POLICY 621

Government Budgets 622Budget Making 622Highlights of the 2011/12 Budget 622The Budget in Historical Perspective 623

Supply-Side Effects of Fiscal Policy 628Full Employment and Potential GDP 628The Effects of the Income Tax 628Taxes on Expenditure and the Tax Wedge 629Taxes and the Incentive to Save and Invest 630Tax Revenues and the Laffer Curve 631The Supply-Side Debate 631

Fiscal Stimulus 632Automatic Fiscal Policy and Cyclical andStructural Budget Balances 632

Discretionary Fiscal Stimulus 633

READING BETWEEN THE LINESSwans Fiscal Policy 638


xxviii CONTENTS

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CHAPTER 28 MONETARY POLICY 645

Monetary Policy Objectives and Framework 646Monetary Policy Objective 646Statement on the Conduct of Monetary Policy 646

Actual Inflation 646Responsibility for Monetary Policy 647

The Conduct of Monetary Policy 648The Monetary Policy Instrument 648The Banks Interest Rate Decision 649Hitting the Cash Rate Target 649

Monetary Policy Transmission 651Quick Overview 651Interest Rate Changes 651 Exchange Rate Fluctuations 652Money and Bank Loans 653The Long-Term Real Interest Rate 653Expenditure Plans 653The Change in Aggregate Demand, Real GDPand the Price Level 654

The Reserve Bank Fights Recession 654The Reserve Bank Fights Inflation 656Loose Links and Long and Variable Lags 657

Extraordinary Monetary Stimulus 659The Key Elements of the Crisis 659The Policy Actions 660Painfully Slow Recovery 660Policy Strategies and Clarity 660

READING BETWEEN THE LINESThe Reserve Bank Fights Recession in 2011 662


Glossary G1Index I1

CONTENTS xxix

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Copyright holders for the photos used in this book areshown below.

Chapter 11 Andresr | Shutterstock; 5 AFP | Getty Images AustraliaPty Ltd; 6 (left) JJM Stock Photography | Alamy;(right) Dave Massey | Dreamstime.com; 7 Bloomberg |Getty Images Australia Pty Ltd.

Chapter 229 Kadmy | Dreamstime.com; 32 Barbara Reddoch |Dreamstime.com; 41 (left) Bloomberg via GettyImages; (right) David R. Frazier Photolibrary, Inc. |Alamy.

Chapter 351 Beau Lark | Corbis; 65 Eyeidea |Dreamstime.com; 67 Australian Financial Review 2011Fairfax Syndication.

Chapter 18 397 Alex Segre | Alamy; 406 (left) 2010 Getty Images;(right) Bloomberg via Getty Images; 407 (left) 2010AFP. AFP | Getty Images; (right) Image Source | GettyImages.

Chapter 19 421 Dmitriy Shironosov | Alamy; 422 Corbis.

Chapter 20443 JLImages | Alamy; 455 Science and Society PictureLibrary; 456 AP Photo | Jose Silva Pinto.

Chapter 21469 Andrew Watson | Getty Images; 473 (top) Frontpage |Shutterstock.com; (bottom) Frontpage | Shutterstock.com;485 Scott J. Ferrell | Congressional Quarterly | GettyImages.

Chapter 22493 George M. | Fotolia.

Chapter 23519 Greg Balfour Evans | Alamy.

Chapter 24 545 redbrickstock.com | Alamy; 552 (column 1) (left)Bloomberg via Getty Images; (right) AAP IMAGE;(column 2) (top left) Getty Images; (top right) Bloombergvia Getty Images; (bottom left) Bloomberg via GettyImages; (bottom right) Bloomberg via Getty Images.

Chapter 25 569 Bloomberg via Getty Images.

Chapter 26 599 Newspix | News Ltd | 3rd Party ManagedReproduction & Supply Rights.

Chapter 27621 Phillip Minnis | Alamy; 637 (top) Roll Call | GettyImages; (middle) Robert J. Barro; (bottom) Estate ofMischa Richeter and Harald Bakken.

Chapter 28645 Bloomberg via Getty Images.

xxxi

PHOTO CREDITS

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Documents

Macro 1