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ECONOMICS

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ELEVENTH EDITION

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Economics

David C. Colander

Middlebury College

ECONOMICS, ELEVENTH EDITION

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About the

Author

Courtesy of David Colander

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David Colander is Distinguished College Professor at Middlebury College.

He has authored, coauthored, or edited over 40 books and over 200 articles on a

wide range of economic topics.

He earned his BA at Columbia College and his MPhil and PhD at Columbia

University

. He also studied at the University of Birmingham in England and at

Wilhelmsburg Gymnasium in Germany. Professor Colander has taught at

Columbia University, Vassar College, the University of Miami, and Princeton

University as the Kelley Professor of Distinguished Teaching. He has also been

a consultant to Time-Life Films, a consultant to Congress, a Brookings Policy

Fellow, and Visiting Scholar at Nuffield College, Oxford.

Professor Colander has been president of both the History of Economic

Thought Society and the Eas

tern Economics Association. He has also served on

the editorial boards of The Journal of Economic Perspectives, The Journal of

Economic Education, The Journal of Economic Methodology, The Journal of the

History of Economic Thought, The Journal of Socio-Economics, and The Eastern

Economic Journal. He has been chair of the American Economic Association

Committee on Electronic Publishing, a member of the AEA Committee on

Economic Education, and is currently the associate editor for content of The

Journal of Economic Education.

He is married to a pediatrician, Patrice. In their spare time, the Colanders

designed and built an oak post-and-beam house on a ridg

e overlooking the Green

Mountains to the east and the Adirondacks to the west. The house is located on

the site of a former drive-in movie theater. (They replaced the speaker poles with

fruit trees and used the I-beams from the screen as support for the second story of

the carriage house and the garage.) They now live in both Florida and Vermont.

Preface

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Economics is about ideas, not models. The goal of this

text is to convey to students the ideas that make up mod-

ern economics. The ideas are both about the way the

economy works, and about how to design policy to make

the economy work better.

How This Book Differs

from Others

Ideas are nuanced; models are not. From its beginning, this

book has provided a nuanced narrative that emphasizes

both ideas and models. Its distinctive features have been

itsconversational style and its inclusion of different views

within mainstream economics. It doesn’t offer a cookie cut-

ter presentation of material, but instead offers a blend of

logical model building and nuanced discussion of applying

the models. The writing style is conversational, designed to

allow the student to feel a connection with me—the

writer—to make it clear that I am a human being, not a ma-

chine. This approach is particularly welcomed as students

spend more and more time learning material online.

Even while spending a lot of time online, students seek

personal connections. It still makes my day when students

whom I’ve never met in person write me thanking me for

making the course fun and for relating to them. I’m delighted

with the reception this book has received, and the loyal

following who have used, and continue to use, the book.

While the book is consciously mainstream, it differs from

most other top books in its tone. It presents economic theory

more as a changing heuristic than as an unchanging scientific

theory. So, while the discussion of the models is the same as

in other books, the discussion of the application of the mod-

els is different. I emphasize the difficulties of applying the

models while most principles books gloss over them.

Nuanced Economics: Teaching

More Than Models

Recent economic pedagogy has shifted away from seeing

textbooks as a narrative, to seeing them as a compilation

of models that can be presented in separable building

blocks or modules. This modularization of the teaching of

economic principles involves dividing economic knowl-

edge into learning objectives, sub learning objectives, and

sub-sub learning objectives.

This building block approach makes lots of sense as

long as one remembers that you also need mortar and

architectural blueprints to hold the building blocks to-

gether

. That mortar and those blueprints are embedded in

the text’s narrative. Unfortunately, mortar and blueprints

don’t fit nicely into building block modules captured by

learning objectives. Mortar and blueprints require con-

ceptualization that goes beyond the standard models—

conceptualization that brings the big picture into focus.

And, because there are a variety of architectural blue-

prints, there is not a single, but a variety of, big pictures;

models highlight only one of those blueprints.

The study of such issues is the grist for “big think”

economics that characterizes this book where nuance is

integrated into understanding, and students see the im-

portance of mortar. Consideration of such issues often

goes under the heading of critical thought. To learn to

think critically students have to be presented with some

questions without definitive answers, but ones upon

which, when addressed creatively, economic models can

shed light. My book contains lots of such questions.

My approach to models follows the approach Alfred

Marshall used back when he first introduced the supply/

demand model into the principles course. Marshall em-

phasized that economics was an approach to problems,

not a body of confirmed truths. In my view, the modeling

method, not the models, is the most important element of

an economic understanding. In my presentation of mod-

els, I carefully try to guide students in the modeling

method, rather than having them memorize truths from

models. I carefully emphasize the limitations of the mod-

els and the assumptions that underlie them, and am con-

stantly urging students to think beyond the models. This

approach pushes the students a bit harder than the alterna-

tive, but it is, in my view, the best pedagogical approach;

it is the critical thinking approach.

When taking a critical thinking approach two princi-

ples stand out: (1) Institutions and history are important

in policy discussions and (2) good economics is open to

dealing with various viewpoints. Let me discuss each of

these principles briefly.

Institutions and History Are Important to

Understand Policy

If you open up Adam Smith’s Wealth of Nations, John

Stuart Mill’s Principles of Political Economy, or Alfred

Marshall’s Principles of Economics, you will see eco-

nomic analysis placed in historical and institutional

Preface vii

context. The modern textbook template moved away from

that, and in previous editions, I have tried to return the

principles of economics toward that broader template,

presenting models in a historical and institutional context.

This edition continues that emphasis on institutions and

history. Modern work in game theory and strategic deci-

sion making is making it clear that the implications of

economic reasoning depend on the institutional setting.

To understand economics requires an understanding of

existing institutions and the historical development of

those institutions. In a principles course we don’t have

time to present much about history and institutions,

butthat does not preclude us from letting students know

that these issues are important. And that’s what I try to do.

When I say that institutions and history are important,

I am talking especially about economic policy. This text

and the accompanying supplements are not designed for

future economics majors. Most principles students aren’t

going to go on in economics. I write for students who will

probably take only one or two economics courses in their

lifetime. These students are interested in policy, and what

I try to present to them is modern economic reasoning

relevant to policy questions.

Because I think policy is so important in explaining

how to apply economic reasoning, I utilize a distinction

made by J. N. Keynes (John Maynard Keynes’ father) and

Classical economists generally. That distinction is be-

tween theorems—the deductive conclusions of models—

and precepts—the considered judgments of economists

about the policy implications of the models. I make it

clear to students that models do not tell us what to do

about policy—they give us theorems. Only when we

combine the models’ results with our understanding of

institutions, our understanding of the social context, and

our understanding of the normative goals we want to

achieve, can we arrive at policy conclusions embodied in

precepts.

Openness to Various Views

While I present modern economics, I present it in such a

way that is open to many different points of view. I don’t

present the material as “the truth” but simply as the con-

ventional wisdom. Learning conventional wisdom is a

useful hurdle for all students to jump over. To encourage

students to question conventional wisdom, at the end of

each chapter I include a set of questions—Questions from

Alternative Perspectives—written by economists from a

variety of different perspectives. These include Post-

Keynesian, Feminist, Austrian, Radical, Institutionalist,

and Religious perspectives. Each is described further in

the “Distinguishing Features” section that follows the

preface. The Radical questions come from the Dollars

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and Sense Collective, a group with whom I’ve worked to

coordinate their readers (www.dollarsandsense.org/

bookstore.html) with this text. I also often integrate Aus-

trian ideas into my class; I find that The Free Market

(www.mises.org) is a provocative resource.

I often pair an article in The Free Market with one in

Dollars and Sense in my assignments to students for sup-

plementary reading. Having students read both Radical

and Austrian views, and then integrate those views into

more middle-of-the-road views is, for me, a perfect way

to teach the principles course. (If I have a lot of radicals

and libertarians in the class, I assign them articles that

advocate more middle-of-the-road views.)

Integrating Nuance into the

Learning Platform

Changes in technology are changing the medium through

which ideas are conveyed and the way students learn. Stu-

dents today don’t know a time without the Internet and

social media, which provide them with access to a broad

range of digital resources and instant feedback. Technol-

ogy has changed the way they learn, and if we are to reach

them, we have to present material in ways that fit their

learning style. They want to be able to access their

courses anywhere, anytime—at a coffee shop in the after-

noon, in their dorm room late at night, or at lunch hour at

work. They still want material that speaks to them, but it

has to speak to them in their language at the time they

want to listen. Modern learning is blended learning in

which online presentations, review, testing of material,

and feedback are seamlessly blended with the narrative of

the text. This revision is designed to improve what the

publisher calls the learning platform in both the content

presented and in the delivery of that content.

I think of this book as consisting of both the text and

the delivery system for the text. For the book to succeed,

the online delivery system has to deliver the material to

students in a manner that they can access both online and

in the physical book. The new reality of accessing books

online has driven important changes in the last edition,

and in this edition. Specifically, while the content and

pedagogical approach described above remain largely the

same, the delivery is different.

In the last two editions the learning platform was re-

fined, and all of the content, including end-of-chapter

questions, was made to line up directly with learning

objectives. These learning objectives serve as the organi-

zational structure for the material. The learning objectives

themselves were broken down into further learning objec-

tives associated with concepts that are presented in bite-

sized portions of the text as part of the SmartBook offer.

viii Preface

This now allows students the opportunity to master con-

cepts that support the larger picture no matter how they

access it in the Colander learning platform. Within

McGraw-Hill’s Connect and SmartBook platforms, stu-

dents can learn the core building blocks online with in-

stant feedback; instructors can assess student learning data

and know what their students understand, and what they

don’t. With that information, they can devote class time to

those issues with which students are having problems.

In the previous two editions, the end-of-chapter ma-

terial was also restructured for online delivery: All of

the standard questions and problems were made auto-

gradable and integrated with the online experience.

Such integration allows students to move seamlessly

between homework problems and portions of the narra-

tive to get the information they need, when they need it.

This is a significant advance in pedagogy. Now, even

professors inlarge lecture classes can assign questions

and exercises at the end of chapters and provide feed-

back to students at the point of need.

While the new learning platforms made the teaching

of the building blocks easier, they presented a challenge

for my approach that emphasized the nuance of interpre-

tation as a key element of what students were to learn.

That discussion of nuance was scattered throughout the

text; it wasn’t a building block to be learned in one place.

Rather it was mortar to be learned over the course of the

entire semester. This learning goal did not come through

in the learning platform as strongly as it did in the text it-

self. While the modular learning platform worked well in

teaching a building block approach to models, it didn’t

work so well helping students understand the context of

the models. It provided the building blocks but not the

mortar. So the previous versions of my online learning

platforms emphasized models a bit more than I would

have liked and context a bit less.

The nuance material was still there, but it was not in-

tegrated into the learning platform as much as I thought it

should be. In previous editions, I did what I could to ac-

count for that. Specifically I added aspects of the book

that allowed professors who wanted to emphasize nuance

to do so. These included two sets of end-of-chapter ques-

tions, Issues to Ponder and Questions from Alternative

Perspectives, which have no “correct” answer, but instead

are designed to get the students to think. In a learning

environment that blends both online and in-person expe-

riences, these are the questions that can form the basis for

rich classroom discussions that engage the students with

broad issues as much as the online material engages them

with the building blocks.

In this edition I go a step further in integrating nuance

into the course. Specifically, I have essentially made

coL25585_fm_i-xxxii_1.indd 8 11/24/18 11:03 AM

nuance its own general learning objective—a learning

objective that relates to the entire book. So in addition to

the learning objectives specific to individual chapters,

there is a general learning objective that is relevant to all

chapters. The general learning objective—the mortar

that holds the building blocks together—is: Know that to

relate models to the real world, you need to use a nuanced

approach.

For professors who want to include this learning ob-

jective in their course, I have written a prologue to the

student found on pages P-1 to P-5, just before Chapter 1.

In it I discuss the need for context and nuance in applying

the models, and introduce students to two methodological

tools that philosophers use to move from models to policy

positions. This prologue, what you might think of as

Chapter 0, serves as the mortar and blueprint to guide stu-

dents in thinking critically about the models and their

application. This short prologue, which can be assigned

along with Chapter 1, presents a general discussion of the

problem of context and nuance and introduces the general

learning objective.

Students are reminded of this general learning objec-

tive throughout the book in chapter discussions of nu-

anced issues, which are highlighted in SmartBook and

probes that focus on nuance. I also provide professors

with some guidance and suggestions on how to integrate

a discussion of values and ethics into the course, along

with a list of Connect questions and material in SmartBook

that deal with integrating values into the analysis. These

are to be found in the Instructor’s website for the book. For

those who want to emphasize critical thought and nuance

in the course, it is much easier to do so than before.

Specific Content Changes

to This Edition

Any new edition provides the possibility to update dis-

cussions and I have done so throughout the book, both in

updating references to events, and in examples. On a

mundane level I changed examples and products being

discussed. For example, there was an earlier discussion of

the supply and demand for CDs, which at one point in the

past seemed reasonable. CDs have gone the way of buggy

whips, and so the discussion was changed to chocolate,

which has a longer shelf life—there will always be

demand for 80 percent dark chocolate, at least from me.

I also reviewed all the boxes, eliminating or updat-

ing those that were outdated, replacing them with new

boxes that capture some of the new ideas being dis-

cussed. For example, in Chapter 3 I added a box on

polycentric government and the ideas of economist

Preface ix

Elinor Ostrom, and in Chapter 8W I updated the discus-

sion of the farm program.

I did the same with discussions in the text, adding up-

dates where needed. That led to substantial changes in

some chapters. For example, President Trump’s changing

the narrative on trade meant some significant changes in

Chapter 10 on trade were needed. I replaced the opening

discussion of trade to include Trump’s criticism of

freetrade agreements and updated the discussion of WTO

trade negotiations and U.S. trade policy to account for the

Trump presidency. The growing importance of platform

monopolies and network externalities led to substantial

changes in Chapter 14 and the discussion of antitrust pol-

icy in Chapter 15. Chapter 17 on labor also was modified

to account for developments in the information revolu-

tion. I also added discussions of artificial intelligence and

deep learning in both the micro and macro chapters.

These developments will likely have significant implica-

tions for the economy in the coming decade, as AI and

deep learning do to mental labor what the Industrial

Revolution did to physical labor.

Because of the c

hanging nature of the macro problem

facing the economy, macro examples were updated more

frequently than micro examples. In this edition the dis-

cussion of the macro economy is from the perspective of

2018. The economy is strong, but there is continuing con-

cern that the growth is not sustainable. The monetary

policy discussion involved substantial changes since the

Fed is no longer using unconventional monetary policy,

but is instead trying to unwind its balance sheet as it

returns to a conventional monetary policy.

The use of fiscal policy also changed, wit

h the tax cut

and spending increase, even as the economy was doing

well, showing how politics generally trumps economics

in driving fiscal policy. Another change in the macro

chapters involved discussions of cryptocurrencies and

how they are not currencies, since they don’t meet the

definition of money, but are instead crypto assets, almost

designed to be blown into bubbles. I discuss how block-

chain technology might be revolutionary, but the hype

around cryptocurrency is more like Tulipmania and how

the real revolution in currency is more likely to come

through new digital currencies such as M-Pesa.

Finally, there were a number of changes to allow the

introduction of nuanced understanding as a separate

learning objective. I added a discussion of Adam Smith’s

impartial spectator tool, and how in assessing policy, one

must go beyond how it will benefit oneself, and concen-

trate on how it can be judged from society’s point of view.

I encourage students to discuss contentious policy issues

with others who approach the issues differently as a way

of advancing the discussion.

Enjoy!

In summary, this book differs from others in its distinc-

tive blend of nuance and no-nonsense modeling. Working

with models doesn’t involve nuance; it involves knowing

the models and their assumptions—questions about mod-

els are right or wrong—and nuanced discussion of apply-

ing the models where there are inevitably gray areas

where critical thought is needed. Seeing students navigate

this gray area and arrive at a nuanced understanding of

economic principles gives me enormous joy. I hope it

does for you as well.

People to Thank

Let me conclude this preface by thanking the hundreds of

people who have offered suggestions, comments, kudos,

and criticism on this project since its inception. This book

would not be what it is without their input. So many peo-

ple have contributed to this text in so many ways that I

cannot thank everyone. So, to all the people who helped—

many, many thanks. I specifically want to thank the

ele venth edition reviewers, whose insightful comments

kept me on track. Reviewers include:

Catherine M. Chambers

University of Central

Missouri

Frankie P. Albritton Jr.

Seminole State College

Paul Chambers

University of Central

Missouri

B. Andrew Chupp

Georgia Institute of

Technology

Diane Cunningham

Los Angeles Valley College

Gregory E. DeFreitas

Hofstra University

John P. Finnigan

Marist College

Bernhard Georg Gunter

American University

Benjamin Leyden

Univer

sity of Virginia

Victoria Miller

Akin Technical College

ABM E. Nasir

North Car

olina Central

University

Christina Ann Robinson

Central Connecticut

State University

William Shambora

Ohio University

Mark Griffin Smith

Colorado College

Don Uy-Barreta

De Anza College

Kenneth Woodward

Saddleback College

In addition to the comments of the formal reviewers

listed above, I have received helpful suggestions, encour-

agement, and assistance from innumerable individuals

via e-mails, letters, symposia, and focus groups. Their

help made this edition even stronger than its predecessor.

They include James Wetzel, Virginia Commonwealth

University; Dmitry Shishkin, Georgia State University;

coL25585_fm_i-xxxii.indd 9 12/3/18 11:54 AM

x Preface

Amy Cramer, Pima Community College–West; Andrea

Terzi, Franklin College; Shelby Frost, Georgia State Uni-

versity; Doris Geide-Stevenson, Weber State University;

James Chasey, Advanced Placement Economics Teaching

Consultant and Homewood-Flossmoor High School

(ret.); David Tufte, Southern Utah University; Eric

Sarpong, Georgia State University; Jim Ciecka, DePaul

University; Fran Bradley, George School; Ron Olive,

University of Massachusetts–Lowell; Rachel Kreier,

Hofstra University; Kenneth Elzinga, University of Vir-

ginia; Ben Leyden, University of Virginia; Poul Thøis

Madse, Danmarks Medie—OG Journalistehojskole; Rich

Tarmey, Colorado Mountain College; Michael Mandelberg,

Stuart Webber, Trinity Lutheran College; Bob Rogers,

Ashland University; Zackery Hansen, Southern Utah

University; and Matt Gaffney, Missouri State University.

I want to give a special thank-you to the supplement

authors and subject matter experts including Jennifer

Rester Savoie, Pearl River Community College; Susan

Bell, Seminole State University; Per Norander, University

of North Carolina at Charlotte; Frankie P. Albritton Jr.,

Seminole State University; and Kenneth Woodward,

Saddleback College. They all did an outstanding job.

I’d also like to thank the economists who wrote the

alternative perspective questions. These include Ann

Mari May of the University of Nebraska–Lincoln, John

Miller of Wheaton College, Dan Underwood of Peninsula

College, Ric Holt of Southern Oregon University, and

Bridget Butkevich of George Mason University. I enjoyed

working with each of them, and while their views often

coL25585_fm_i-xxxii.indd 10 12/3/18 12:42 PM

differed substantially, they were all united in wanting ques-

tions that showed economics as a pluralist field that en-

courages students to question the text from all perspectives.

I have hired numerous students to check aspects of the

book, to read over my questions and answers to questions,

and to help proofread. For this edition, these include Reid

Smith, Amelia Pollard and Zhewei Yang. I thank them all.

A special thank-you for this edition goes to two peo-

ple. The first is Jenifer Gamber, whose role in the book

cannot be overestimated. She helped me clarify its vision

by providing research, critiquing expositions and often

improving them, and being a good friend. She has an

amazing set of skills, and I thank her for using them to

improve the book. The second is Christina Kouvelis,

senior pr oduct developer, who came into this project and

with her hard work, dedication, and superb ability made it

possible to get the book done on time. She and Jenifer are

two amazing women.

Next, I want to thank the entire McGraw-Hill team,

including Terri Schiesl, managing director; Anke Weekes,

director; Christine Vaughan, lead content project man-

ager; Bruce Gin, senior assessment project manager;

Egzon Shaqiri, designer; Bobby Pearson, marketing man-

ager; Julia Blankenship, marketing specialist; and Doug

Ruby, director of digital content. All of them have done a

superb job, for which I thank them sincerely.

Finally, I want to thank Pat, my wife, and my sons,

Kasey and Zach, for helping me keep my work in per-

spective, and for providing a loving environment in which

to work.

Distinguishing

Features

Margin Comments

Located throughout the text in the margin, these key take-

aways underscore and summarize the importance of the

material, at the same time helping students focus on the

most relevant topics critical to their understanding.

Margin Questions

These self-test questions are presented in the margin of

the chapter to enable students to determine whether the

preceding material has been understood and to reinforce

understanding before students read further. Answers to

Margin Questions are found at the end of each chapter.

Web Notes

This feature extends the text discussion onto the web.

Web Notes are denoted within the margins, and are

housed within Connect and featured in SmartBook.

Nuance Prologue and Questions

Nuanced aspects of economics are presented throughout

the book, and in a Prologue for the Student. In SmartBook,

nuance questions have been added that directly relate to

applying the models and the problems of integrating values

into theanalysis. A guide to these questions can be found

on the Instructor Resource website.

Issues to Ponder

Each chapter ends with a set of Issues to Ponder questions

that are designed to encourage additional economic think-

ing and application.

Questions from Alternative

Perspectives

The end-of-chapter material includes a number of ques-

tions that ask students to assess economics from alterna-

tive perspectives. Specifically, six different approaches

are highlighted: Austrian, Post-Keynesian, Institutional-

ist, Radical, Feminist, and Religious. Below are brief

descriptions of each group.

Austrian Economists

Austrian economists believe in methodological individu-

alism, by which they mean that social goals are best met

through voluntary, mutually beneficial interactions. Lack

of information and unsolvable incentive problems under-

mine the ability of government to plan, making the mar-

ket the best method for coordinating economic activity.

Austrian economists oppose state intrusion into private

property and private activities. They are not economists

from Austria; rather, they are economists from anywhere

who follow the ideas of Ludwig von Mises and Friedrich

Hayek, two economists who were from Austria.

Austrian economists are sometimes classified as con-

servative, but they are more appropriately classified as

libertarians, who believe in liberty of individuals first and

in other social goals second. Consistent with their views,

they are often willing to support what are sometimes con-

sidered radical ideas, such as legalizing addictive drugs

or eliminating our current monetary system—ideas that

most mainstream economists would oppose. Austrian

economists emphasize the uncertainty in the economy and

the inability of a government controlled by self- interested

politicians to undertake socially beneficial policy.

Institutionalist Economists

Institutionalist economists argue that any economic analy-

sis must involve specific considerations of institutions. The

lineage of Institutionalist economics begins with the pio-

neering work of Thorstein Veblen, John R. Commons, and

Wesley C. Mitchell. Veblen employed evolutionary analy-

sis to explore the role of institutions in directing and retard-

ing the economic process. He saw human behavior driven

by cultural norms and conveyed the way in which they

were with sardonic wit and penetrating insight, leaving us

with enduring metaphors such as the leisure class and con-

spicuous consumption. Commons argued that institutions

are social constructs that improve general welfare. Accord-

ingly, he established cooperative investigative programs to

support pragmatic changes in the legal structure of govern-

ment. Mitchell was a leader in developing economics as an

empirical study; he was a keen observer of the business

cycle and argued that theory must be informed by system-

atic attention to empirical data, or it was useless.

Contemporary Institutionalists employ the founders’

“trilogy”—empirically informed, evolutionary analysis,

coL25585_fm_i-xxxii_1.indd 11 11/24/18 11:03 AM

xii Preface

directed toward pragmatic alteration of institutions shap-

ing economic outcomes—in their policy approach.

Radical Economists

Radical economists believe substantial equality-preferring

institutional changes should be implemented in our

economic system. Radical economists evolved out of

Marxian economics. In their analysis, they focus on the

lack of equity in our current economic system and on in-

stitutional changes that might bring about a more equita-

ble system. Specifically, they see the current economic

system as one in which a few people—capitalists and

high-level managers—benefit enormously at the expense

of many people who struggle to make ends meet in jobs

that are unfulfilling or who even go without work at

times. They see the fundamental instability and irratio-

nality of the capitalist system at the root of a wide array

of social ills that range from pervasive inequality to alien-

ation, racism, sexism, and imperialism. Radical econo-

mists often use a class-oriented analysis to address these

issues and are much more willing to talk about social

conflict and tensions in our society than are mainstream

economists.

A policy favored by many Radicals is the establish-

ment of worker cooperatives to replace the corporation.

Radicals argue that such worker cooperatives would see

that the income of the firm is more equitably allocated.

Likewise, Radical economists endorse policies, such as

universal health care insurance, that conform to the ethic

of “putting people before profits.”

Feminist Economists

Feminist economics offers a substantive challenge to the

content, scope, and methodology of mainstream econom-

ics. Feminist economists question the boundaries of what

we consider economics to be and examine social arrange-

ments surrounding provisioning. Feminist economists

have many different views, but all believe that in some

way traditional economic analysis misses many important

issues pertaining to women.

Feminist economists study issues such as how the in-

stitutional structure tends to direct women into certain

types of jobs (generally low-paying jobs) and away from

other types of jobs (generally high-paying jobs). They

draw our attention to the unpaid labor performed by

women throughout the world and ask, “What would GDP

look like if women’s work were given a value and

included?” They argue for an expansion in the content of

coL25585_fm_i-xxxii_1.indd 12 11/24/18 11:03 AM

economics to include women as practitioners and as

worthy of study and for the elimination of the masculine

bias in mainstream economics. Is there such a bias? To

see it, simply compare the relative number of women in

your economics class to the relative number of women at

your school. It is highly likely that your class has relatively

more men. Feminist economists want you to ask why that

is, and whether anything should be done about it.

Religious Economists

Religion is the oldest and, arguably, the most influential

institution in the world—be it Christianity, Islam, Juda-

ism, Buddhism, Hinduism, or any of the many other reli-

gions in the world. Modern science, of which economics

is a part, emphasizes the rational elements of thought. It

attempts to separate faith and normative issues from ra-

tional analysis in ways that some religiously oriented

economists find questionable. The line between a reli-

gious and nonreligious economist is not hard and fast; all

economists bring elements of their ethical considerations

into their analysis. But those we call “religious econo-

mists” integrate the ethical and normative issues into eco-

nomic analysis in more complex ways than the ways

presented in the text.

Religiously oriented economists have a diversity of

views; some believe that their views can be integrated

reasonably well into standard economics, while others

see the need for the development of a distinctive faith-

based methodology that focuses on a particular group of

normative concerns centered on issues such as human

dignity and caring for the poor.

Post-Keynesian Economists

Post-Keynesian economists believe that uncertainty is a

central issue in economics. They follow J. M. Keynes’ ap-

proach more so than do mainstream economists in em-

phasizing institutional imperfections in the economy and

the importance of fundamental uncertainty that rational-

ity cannot deal with. They agree with Institutionalists that

the study of economics must emphasize and incorporate

the importance of social and political structure in deter-

mining market outcomes.

While their view about the importance of uncertainty

is similar to the Austrian view, their policy response to

that uncertainty is quite different. They do not see uncer-

tainty as eliminating much of government’s role in the

economy; instead, they see it leading to policies in which

government takes a larger role in guiding the economy.

xiii

Supplements

coL25585_fm_i-xxxii.indd 13 12/3/18 11:55 AM

McGraw-Hill has established a strong history of top-rate

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2 The Production Possibility Model, Trade, and

Globalization 25

Appendix: Graphish:The Language of Graphs 44

3 Economic Institutions 53

Appendix: The History of Economic Systems 73

4 Supply and Demand 78

5 Using Supply and Demand 101

Appendix: Algebraic Representation of Supply,

Demand, and Equilibrium 117

 II MICROECONOMICS

THE POWER OF TRADITIONAL

ECONOMIC MODELS

6 Describing Supply and Demand: Elasticities 124

7 Taxation and Government Intervention 144

8 Market Failure versus Government Failure 165

8W Politics and Economics: The Case of Agricultural

Markets 187

INTERNATIONAL ECONOMIC

POLICYISSUES

9 Comparative Advantage, Exchange Rates,

and Globalization 188

10 International Trade Policy 207

PRODUCTION AND COST ANALYSIS

11 Production and Cost Analysis I 229

12 Production and Cost Analysis II 249

Appendix: Isocost/Isoquant Analysis 267

MARKET STRUCTURE

13 Perfect Competition 272

14 Monopoly and Monopolistic Competition 293

Appendix: The Algebra of Competitive and

Monopolistic Firms 319

15 Oligopoly and Antitrust Policy 321

16 Real-World Competition and Technology 340

FACTOR MARKETS

17 Work and the Labor Market 359

Appendix: Derived Demand 383

17W Nonwage and Asset Income: Rents, Profits, and

Interest 389

18 Who Gets What? The Distribution of Income 390

CHOICE AND DECISION MAKING

19 The Logic of Individual Choice:

The Foundation ofSupply and Demand 416

Appendix: Indifference Curve Analysis 436

20 Game Theory, Strategic Decision Making, and

Behavioral Economics 441

Appendix: Game Theory and Oligopoly 462

MODERN ECONOMIC THINKING

21 Thinking Like a Modern Economist 466

22 Behavioral Economics and Modern Economic

Policy 492

23 Microeconomic Policy, Economic Reasoning,

and Beyond 511

 III MACROECONOMICS

MACROECONOMIC BASICS

24 Economic Growth, Business Cycles, and

Unemployment 534

25 Measuring and Describing the Aggregate

Economy 557

POLICY MODELS

26 The Keynesian Short-Run Policy Model:

Demand-Side Policies 582

26W The Multiplier Model 609

27 The Classical Long-Run Policy Model: Growth and

Supply-Side Policies 610

FINANCE, MONEY, AND THE ECONOMY

28 The Financial Sector and the Economy 631

Appendix: A Closer Look at Financial Assets and

Liabilities 653

29 Monetary Policy 659

xvi

Brief

Contents

coL25585_fm_i-xxxii_1.indd 16 11/24/18 11:03 AM

 I INTRODUCTION: THINKING

LIKE AN ECONOMIST

11 Economics and Economic Reasoning 4

30 Financial Crises, Panics, and Unconventional

Monetary Policy 681

TAXES, BUDGETS, AND

FISCAL POLICY

31 Deficits and Debt: The Austerity Debate 701

32 The Fiscal Policy Dilemma 718

MACROECONOMIC PROBLEMS

33 Jobs and Unemployment 736

34 Inflation, Deflation, and Macro Policy 754

INTERNATIONAL MACROECONOMIC

POLICY ISSUES

35 International Financial Policy 777

Appendix: History of Exchange Rate Systems 802

36 Macro Policy in a Global Setting 805

37 Structural Stagnation and Globalization 820

Appendix: Creating a Targeted Safety Net to Help the

Least Well Off 843

38 Macro Policy in Developing Countries 845

Brief Contents xvii

coL25585_fm_i-xxxii_1.indd 17 11/24/18 11:03 AM

xviii

Trade and Comparative Advantage 32

Markets, Specialization, and Growth 33

The Benefits of Trade 34

Globalization and the Law of One Price 36

Globalization 36

Exchange Rates and Comparative Advantage 38

The Law of One Price 38

Globalization and the Timing of Benefits of Trade 39

Conclusion 39

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 40–43

Appendix: Graphish: The Language of Graphs 44

3 Economic Institutions 53

Economic Systems 54

How Markets Work 54

What’s Good about the Market? 55

Capitalism and Socialism 55

Economic Institutions in a Market Economy 58

Business 59

Households 61

The Roles of Government 62

Government as an Actor 62

Government as a Referee 64

Specific Roles for Government 65

Market Failures and Government Failures 67

Global Institutions 68

Global Corporations 68

Coordinating Global Issues 68

Conclusion 69

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 69–72

Appendix: The History of Economic Systems 73

4 Supply and Demand 78

Demand 78

The Law of Demand 79

The Demand Curve 79

2 The Production Possibility Model, Trade,

and Globalization 25

The Production Possibility Model 26

A Production Possibility Curve for an Individual 26

Increasing Opportunity Costs of the Trade-Off 27

Comparative Advantage 28

Efficiency 29

Distribution and Productive Efficiency 30

Examples of Shifts in the PPC 31

Contents

coL25585_fm_i-xxxii_1.indd 18 11/24/18 11:03 AM

PART I

INTRODUCTION:

THINKING LIKE

AN ECONOMIST

11 Economics and Economic Reasoning 4

What Economics Is 5

Scarcity 5

Microeconomics and Macroeconomics 6

A Guide to Economic Reasoning 6

Marginal Costs and Marginal Benefits 8

The Economic Decision Rule 8

Economics and Passion 8

Opportunity Cost 9

Economic Forces, Social Forces, and Political Forces 11

Economic and Market Forces 11

Social and Political Forces 11

Using Economic Insights 13

The Invisible Hand Theorem 14

Economic Theory and Stories 15

Economic Institutions 15

Economic Policy Options 16

Objective Policy Analysis 17

Policy and Social and Political Forces 20

Conclusion 20

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 21–24

Shifts in Demand versus Movements

along a Demand Curve 80

Some Shift Factors of Demand 81

The Demand Table 82

From a Demand Table to a Demand Curve 82

Individual and Market Demand Curves 83

Supply 85

The Law of Supply 85

The Supply Curve 86

Shifts in Supply versus Movements along a Supply

Curve 87

Shift Factors of Supply 88

The Supply Table 88

From a Supply Table to a Supply Curve 88

Individual and Market Supply Curves 88

The Interaction of Supply and Demand 89

Equilibrium 90

The Graphical Interaction of Supply and Demand 91

What Equilibrium Isn’t 91

Political and Social Forces and Equilibrium 92

Shifts in Supply and Demand 93

A Limitation of Supply/Demand Analysis 95

Conclusion 95

Summary, Key Terms, Questions and Exercises,

Questions from Alternative Perspectives,

Issues to Ponder, Answers to

Margin Questions 96–100

5 Using Supply and Demand 101

Real-World Supply and Demand

Applications 101

Government Intervention: Price Ceilings

and Price Floors 104

Price Ceilings 105

Price Floors 106

Government Intervention: Excise Taxes

and Tariffs 108

Government Intervention: Quantity

Restrictions 109

Third-Party-Payer Markets 111

Conclusion 112

Summary, Key Terms, Questions and Exercises,

Questions from Alternative Perspectives,

Issues to Ponder, Answers to

Margin Questions 112–116

Appendix: Algebraic Representation of Supply, Demand,

and Equilibrium 117

PART II

MICROECONOMICS

THE POWER OF TRADITIONAL

ECONOMIC MODELS

6 Describing Supply and Demand:

Elasticities 124

Price Elasticity 124

What Information Price Elasticity Provides 125

Classifying Demand and Supply as Elastic

or Inelastic 125

Elasticity Is Independent of Units 126

Calculating Elasticities 126

Other Examples 128

Elasticity Is Not the Same as Slope 128

Five Terms to Describe Elasticity 130

Substitution and Elasticity 130

Substitution and Demand 131

How Substitution Factors Affect Specific

Decisions 132

Elasticity, Total Revenue, and Demand 133

Total Revenue along a Demand Curve 134

Income and Cross-Price Elasticity 135

Income Elasticity of Demand 135

Cross-Price Elasticity of Demand 136

Some Examples 137

The Power of Supply/Demand Analysis 138

When Should a Supplier Not Raise Price? 138

Elasticity and Shifting Supply and Demand 139

Conclusion 139

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 140–143

7 Taxation and Government

Intervention 144

Producer and Consumer Surplus 144

Burden of Taxation 146

Who Bears the Burden of a Tax? 148

Tax Incidence and Current Policy Debates 151

Government Intervention as Implicit Taxation 152

Price Ceilings and Floors 152

The Difference between Taxes and Price

Controls 153

Contents xix

coL25585_fm_i-xxxii_1.indd 19 11/24/18 11:03 AM

xx Contents

Rent Seeking, Politics, and Elasticities 154

Inelastic Demand and Incentives to Restrict Supply 154

Inelastic Supplies and Incentives to Restrict Prices 157

The Long-Run/Short-Run Problem of Price

Controls 158

Conclusion 160

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 160–164

8 Market Failure versus Government

Failure 165

Externalities 166

Effects of Positive and Negative Externalities 167

Alternative Methods of Dealing with

Externalities 168

Direct Regulation 169

Incentive Policies 170

Voluntary Reductions 171

The Optimal Policy 172

Public Goods 172

The Market Value of a Public Good 173

Excludability and the Costs of Pricing 175

Informational and Moral Hazard Problems 176

Signaling and Screening 177

Policies to Deal with Informational Problems 177

Government Failure and Market Failures 180

Conclusion 182

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 182–186

8W Politics and Economics: The Case of

Agricultural Markets 187 and 8W-1

The Good/Bad Paradox in Agriculture 8W-3

The Long-Run Decline of Farming 8W-3

The Short-Run Cyclical Problem Facing Farmers 8W-4

The Difficulty of Coordinating Farm Production 8W-4

Ways around the Good/Bad Paradox 8W-4

The General Rule of Political Economy 8W-5

Four Price Support Options 8W-5

Supporting the Price by Regulatory Measures 8W-6

Providing Economic Incentives to Reduce Supply 8W-8

Subsidizing the Sale of the Good 8W-9

Buying Up and Storing, Giving Away, orDestroying

the Good 8W-9

Which Group Prefers Which Option? 8W-10

Economics, Politics, and Real-World Policies 8W-10

Interest Groups 8W-11

International Issues 8W-12

Conclusion 8W-12

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 8W-13–8W-16

INTERNATIONAL ECONOMIC POLICY

ISSUES

9 Comparative Advantage, Exchange

Rates, and Globalization 188

The Principle of Comparative Advantage 188

The Gains from Trade 189

Dividing Up the Gains from Trade 190

Why Economists and Laypeople Differ in Their Views

of Trade 192

Gains Are Often Stealth 192

Opportunity Cost Is Relative 192

Trade Is Broader Than Manufactured Goods 192

Trade Has Distributional Effects 193

Sources of U.S. Comparative Advantage 194

Some Concerns about the Future 196

Inherent and Transferable Sources of

Comparative Advantages 196

The Law of One Price 196

How the United States Gained and Is Now Losing

Sources of Comparative Advantage 197

Methods of Equalizing Trade Balances 197

Determination of Exchange Rates and Trade 198

Exchange Rates and Trade 200

Some Complications in Exchange Rates 201

Conclusion 202

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 202–206

10 International Trade Policy 207

The Nature and Patterns of Trade 207

Increasing but Fluctuating World Trade 207

Differences in the Importance of Trade 208

What and with Whom the United States Trades 208

Debtor and Creditor Nations 210

coL25585_fm_i-xxxii_1.indd 20 11/24/18 11:03 AM

Contents xxi

12 Production and Cost

Analysis II 249

Technical Efficiency and Economic

Efficiency 250

The Shape of the Long-Run Cost Curve 250

Economies of Scale 251

Diseconomies of Scale 253

Constant Returns to Scale 254

The Importance of Economies and

Diseconomies of Scale 255

Envelope Relationship 255

Entrepreneurial Activity and the

Supply Decision 257

Using Cost Analysis in the Real World 258

Economies of Scope 258

Learning by Doing and Technological Change 259

Many Dimensions 262

Unmeasured Costs 262

The Standard Model as a Framework 263

Conclusion 263

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 264–267

Appendix: Isocost/Isoquant Analysis 267

MARKET STRUCTURE

13 Perfect Competition 272

Perfect Competition as a Reference Point 272

Conditions for Perfect Competition 273

Demand Curves for the Firm and the Industry 273

The Profit-Maximizing Level of Output 274

Marginal Revenue 274

Marginal Cost 275

Profit Maximization: MC = MR 275

The Marginal Cost Curve Is the Supply Curve 276

Firms Maximize Total Profit 276

Total Profit at the Profit-Maximizing

Level of Output 278

Determining Profit from a Table of Costs and

Revenue 278

Determining Profit from a Graph 279

The Shutdown Point 281

Short-Run Market Supply and Demand 282

Long-Run Competitive Equilibrium:

Zero Profit 283

Varieties of Trade Restrictions 212

Tariffs and Quotas 212

Voluntary Restraint Agreements 214

Sanctions 214

Regulatory Trade Restrictions 215

Nationalistic Appeals and “Buy Domestic”

Requirements 215

Reasons for and against Trade Restrictions 215

Unequal Internal Distribution of the Gains from Trade 216

Haggling by Companies over the Gains from Trade 218

Haggling by Countries over Trade Restrictions 218

Specialized Production 219

Macroeconomic Costs of Trade 220

National Security 221

International Politics 221

Increased Revenue Brought In by Tariffs 221

Why Economists Generally Oppose Trade

Restrictions 221

Institutions Supporting Free Trade 223

Conclusion 225

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 225–228

PRODUCTION AND COST ANALYSIS

11 Production and Cost

Analysis I 229

The Role of the Firm 230

Firms Maximize Profit 231

The Difference between Economists’ Profits and

Accountants’ Profits 232

The Production Process 233

The Long Run and the Short Run 233

Production Tables and Production Functions 233

The Law of Diminishing Marginal Productivity 235

The Costs of Production 236

Fixed Costs, Variable Costs, and Total Costs 236

Average Costs 237

Marginal Cost 237

Graphing Cost Curves 238

Total Cost Curves 239

Average and Marginal Cost Curves 239

Intermission 243

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions, 244–248

coL25585_fm_i-xxxii_1.indd 21 11/24/18 11:03 AM

Adjustment from the Short Run to the Long Run 284

An Increase in Demand 284

Long-Run Market Supply 285

An Example in the Real World 286

Conclusion 287

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 288–292

14 Monopoly and Monopolistic

Competition 293

The Key Difference between a Monopolist and a Perfect

Competitor 293

A Model of Monopoly 294

Determining the Monopolist’s Price and Output

Numerically 294

Determining Price and Output Graphically 295

Comparing Monopoly and Perfect Competition 297

An Example of Finding Output and Price 297

Profits and Monopoly 298

Welfare Loss from Monopoly 300

The Normal Monopolist 300

The Price-Discriminating Monopolist 301

Barriers to Entry and Monopoly 302

Natural Ability 304

Natural Monopolies 304

Network and Platform Monopolies 306

Monopolistic Competition 308

Characteristics of Monopolistic Competition 308

Advertising and Monopolistic Competition 309

Output, Price, and Profit of a Monopolistic

Competitor 311

Comparing Monopoly, Monopolistic Competition,

and Perfect Competition 312

Conclusion 313

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 314–319

Appendix: The Algebra of Competitive and Monopolistic

Firms 319

15 Oligopoly and Antitrust Policy 321

The Distinguishing Characteristics of Oligopoly 321

Models of Oligopoly Behavior 322

The Cartel Model 322

The Contestable Market Model 325

Comparison of the Contestable Market Model

and the Cartel Model 325

Classifying Industries and Markets in Practice 327

The North American Industry Classification

System 328

Empirical Measures of Industry Structure 329

Conglomerate Firms and Bigness 330

Oligopoly Models and Empirical Estimates

of Market Structure 330

Antitrust Policy 331

Judgment by Performance or Structure? 331

The Role of Antitrust in Today’s Economy 333

Conclusion 335

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 336–339

16 Real-World Competition and

Technology 340

Competition Is for Losers 341

The Goals of Real-World Firms

and the Monitoring Problem 341

What Do Real-World Firms Maximize? 344

The Lazy Monopolist and X-Inefficiency 344

The Fight between Competitive and Monopolistic

Forces 346

How Monopolistic Forces Affect Perfect Competition 347

Economic Insights and Real-World Competition 347

How Competitive Forces Affect Monopoly 348

Competition: Natural and Platform Monopolies 349

How Firms Protect Their Monopolies 350

Cost/Benefit Analysis of Creating and

MaintainingMonopolies 351

Establishing Market Position 351

Platform Monopolies and Technology 352

Standards and Winner-Take-All Industries 352

Technological Lock-In 353

Conclusion 354

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 354–358

FACTOR MARKETS

17 Work and the Labor Market 359

The Supply of Labor 360

Real Wages and the Opportunity Cost of Work 361

The Supply of Labor and Nonmarket Activities 362

xxii Contents

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Contents xxiii

Income Taxation, Work, and Leisure 362

The Elasticity of the Supply of Labor 363

Immigration and the International Supply

of Labor 364

The Derived Demand for Labor 364

Factors Influencing the Elasticity of Demand for

Labor 365

Labor as a Factor of Production 365

Shift Factors of Demand 365

Determination of Wages 369

Imperfect Competition and the Labor Market 370

Political and Social Forces and the Labor Market 371

Fairness and the Labor Market 372

Discrimination and the Labor Market 374

Three Types of Direct Demand-Side

Discrimination 374

Institutional Discrimination 376

The Evolution of Labor Markets 377

Evolving Labor Laws 377

The Labor Market and You 377

Conclusion 378

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 379–382

Appendix: Derived Demand 383

17W Nonwage and Asset Income: Rents,

Profits, and Interest 389 and 17W-1

Rent 17W-3

The Effect of a Tax on Land 17W-3

Quasi Rents 17W-4

Rent Seeking and Institutional Constraints 17W-5

Profit 17W-6

Profit, Entrepreneurship, and Disequilibrium

Adjustment 17W-6

Market Niches, Profit, and Rent 17W-7

Interest 17W-7

The Present Value Formula 17W-8

Some Rules of Thumb for Determining Present

Value 17W-9

The Importance of Present Value 17W-11

The Marginal Productivity Theory

of Income Distribution 17W-11

Conclusion 17W-12

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 17W-12–17W-14

18 Who Gets What?

The Distribution of Income 390

Measuring the Distribution of Income,

Wealth, and Poverty 391

The Lorenz Curve 391

U.S. Income Distribution over Time 393

Defining Poverty 394

International Dimensions of Income Inequality 397

The Distribution of Wealth 398

Socioeconomic Dimensions of Income

and Wealth Inequality 400

Income Distribution According to

Socioeconomic Characteristics 400

Income Distribution According to Class 400

Income Distribution and Fairness 403

Philosophical Debates about Equality

and Fairness 403

Fairness and Equality 403

Fairness as Equality of Opportunity 404

The Problems of Redistributing Income 405

Three Important Side Effects of Redistributive

Programs 405

Politics, Income Redistribution, and Fairness 405

Income Redistribution Policies 407

How Successful Have Income Redistribution Programs

Been? 410

Conclusion 411

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 412–415

CHOICE AND DECISION MAKING

19 The Logic of Individual Choice:

The Foundation ofSupply and

Demand 416

Rational Choice Theory 417

Total Utility and Marginal Utility 417

Diminishing Marginal Utility 419

Rational Choice and Marginal Utility 419

Maximizing Utility and Equilibrium 422

An Example of Maximizing Utility 422

Extending the Principle of Rational Choice 423

Rational Choice and the Laws

of Demand and Supply 424

The Law of Demand 424

coL25585_fm_i-xxxii_1.indd 23 11/24/18 11:03 AM

Income and Substitution Effects 425

The Law of Supply 426

Opportunity Cost 427

Applying Economists’ Theory of Choice

to the Real World 427

The Cost of Decision Making 427

Given Tastes 428

Utility Maximization 430

Conclusion 431

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 432–435

Appendix: Indifference Curve Analysis 436

20 Game Theory, Strategic Decision

Making, and Behavioral Economics 441

Game Theory and the Economic

Way of Thinking 442

Game Theory and Economic Modeling 442

The Game Theory Framework 443

The Prisoner’s Dilemma 444

Dominant Strategies and Nash Equilibrium 445

An Overview of Game Theory as a Tool

in Studying Strategic Interaction 447

Some Specific Games 447

Strategies of Players 448

Informal Game Theory and Modern

Behavioral Economics 451

Informal Game Theory 452

Real-World Applications of Informal Game

Theory 452

An Application of Game Theory: Auction

Markets 454

Game Theory and the Challenge to Standard Economic

Assumptions 455

Fairness 455

Endowment Effects 456

Framing Effects 456

Behavioral Economics and the Traditional

Model 456

The Importance of the Traditional Model:

Money Is Not Left on the Table 457

Conclusion 457

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 458–461

Appendix: Game Theory and Oligopoly 462

MODERN ECONOMIC THINKING

21 Thinking Like a Modern

Economist 466

The Nature of Economists’ Models 467

Scientific and Engineering Models 468

Behavioral and Traditional Building Blocks 468

Behavioral Economic Models 468

The Advantages and Disadvantages of Modern Traditional

and Behavioral Models 471

Behavioral and Traditional Informal

(Heuristic)Models 473

The Armchair Economist: Heuristic Models

UsingTraditional Building Blocks 473

The Economic Naturalist: Heuristic Models

UsingBehavioral Building Blocks 476

The Limits of Heuristic Models 477

Empirical and Formal Models 478

The Importance of Empirical Work in Modern

Economics 478

The Role of Formal Models 481

What Difference Does All This Make to Policy? 487

Conclusion 488

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 488–491

22 Behavioral Economics and Modern

Economic Policy 492

Behavioral Economic Policy in Perspective 492

Behavioral Economics and Economic Engineering 493

Economists as Mechanism Design Engineers 494

Behavioral Economics and Mechanism Design 495

Policy Implications of Traditional Economics 497

Choice Architecture and Behavioral

Economic Policy 497

Nudge Policy and Libertarian Paternalism 499

When Are Nudges Needed? 499

Two Types of Nudges 501

The Problems of Implementing Nudges 502

Distinguishing a Nudge from a Push 503

Behavioral and Traditional Economic Policy

Frames 503

Concerns about Behavioral Economic Policies 505

Few Policies Meet the Libertarian Paternalism

Criterion 505

Designing Helpful Policies Is Complicated 505

xxiv Contents

coL25585_fm_i-xxxii_1.indd 24 11/24/18 11:03 AM

Contents xxv

Keynesian Economics 536

The Merging of Classical and Keynesian

Economics 537

Politics as the Driving Force in Macro Policy 537

Two Frameworks: The Long Run and

the Short Run 539

Growth 540

Global Experiences with Growth 541

The Prospect for Future U.S. Growth 542

Business Cycles and Structural Stagnation 542

Describing the Business Cycle 543

Structural Stagnation 545

Unemployment and Jobs 546

How Is Unemployment Measured? 547

Unemployment as a Social Problem 550

Unemployment as Government’s Problem 550

The Future of Unemployment 551

Conclusion 553

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 553–556

25 Measuring and Describing the

Aggregate Economy 557

Aggregate Accounting 558

Calculating GDP 558

The Components of GDP 559

Two Things to Remember about GDP 561

Calculating GDP: Some Examples 563

Some Complications 565

Calculating Aggregate Income 566

Equality of Aggregate Income, Output, and

Production 567

Adjusting for Global Dimensions of Production 568

Inflation: Distinguishing Real from Nominal 568

Real versus Nominal GDP 569

Other Real-World Price Indexes 571

Other Real and Nominal Distinctions 572

Some Limitations of Aggregate Accounting 574

Comparing GDP among Countries 574

GDP Measures Market Activity, Not Welfare 575

Measurement Errors 575

Misinterpretation of Subcategories 575

Genuine Progress Indicator 576

Conclusion 577

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 577–581

It Isn’t Clear Government Knows Better 506

Government Policy May Make the Situation Worse 506

A Changing View of Economists: From Pro-market

Advocates to Economic Engineers 507

Conclusion 507

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 508–510

23 Microeconomic Policy, Economic

Reasoning, and Beyond 511

Economists’ Differing Views about Social Policy 512

How Economists’ Value Judgments Creep into Policy

Proposals 512

The Need for a Worldview 514

Agreement among Economists about Social Policy 514

Economists’ Cost/Benefit Approach

to Government Regulation 515

The Value of Life 515

Comparing Costs and Benefits of Different

Dimensions 517

Putting Cost/Benefit Analysis in Perspective 518

The Problem of Other Things Changing 518

The Cost/Benefit Approach in Context 519

Failure of Market Outcomes 519

Distribution 520

Consumer Sovereignty and Rationality Problems 521

Inalienable Rights 523

Government Failure 524

Conclusion 525

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 527–530

PART III

MACROECONOMICS

MACROECONOMIC BASICS

24 Economic Growth, Business Cycles, and

Unemployment 534

The Historical Development of Macroeconomics 535

From Classical to Keynesian Economics 535

Classical Economics 535

coL25585_fm_i-xxxii_1.indd 25 11/24/18 11:03 AM

POLICY MODELS

26 The Keynesian Short-Run Policy Model:

Demand-Side Policies 582

The Key Insight of the Keynesian AS/AD Model 583

Fixed Price Level 583

The Paradox of Thrift 584

Three Things to Remember about the Keynesian

Model 585

The Components of the AS/AD Model 586

The Aggregate Demand Curve 586

The Slope of the AD Curve 586

Dynamic Price-Level Adjustment Feedback Effects 589

Shifts in the AD Curve 590

The Aggregate Supply Curves 592

The Short-Run Aggregate Supply Curve 592

The Long-Run Aggregate Supply Curve 595

Equilibrium in the Aggregate Economy 596

Integrating the Short-Run and Long-Run Frameworks 597

The Recessionary Gap 598

The Inflationary Gap 599

The Economy beyond Potential 599

Aggregate Demand Policy 599

Some Additional Policy Examples 600

Limitations of the AS/AD Model 602

How Feedback Effects Complicate

the AS/AD

Model 602

Additional Complications That the AS/AD

Model Misses 603

Reality and Models 604

Conclusion 605

Summary, Key Terms, Questions and Exercises,

Questions from Alternative Perspectives,

Issues to Ponder, Answers to

Margin Questions 605–608

26W The Multiplier Model 609 and 26W-1

The Multiplier Model 26W-3

Aggregate Production 26W-3

Aggregate Expenditures 26W-3

Determining the Equilibrium Level

of Aggregate Income 26W-8

The Multiplier Equation 26W-9

The Multiplier Process 26W-10

The Circular-Flow Model and the Intuition

behind the Multiplier Process 26W-12

The Multiplier Model in Action 26W-13

Fiscal Policy in the Multiplier Model 26W-16

Fighting Recession: Expansionary Fiscal Policy 26W-16

Fighting Inflation: Contractionary Fiscal Policy 26W-17

Using Taxes Rather Than Expenditures

as the Tool of Fiscal Policy 26W-18

Limitations of the Multiplier Model 26W-19

The Multiplier Model Is Not a Complete Model

of the Economy 26W-19

Shifts Are Sometimes Not as Great as the Model

Suggests 26W-19

Fluctuations Can Sometimes Be Greater

Than the Model Suggests 26W-20

The Price Level Will Often Change in Response

to Shifts in Demand 26W-20

People’s Forward-Looking Expectations

Make the Adjustment Process Much

More Complicated 26W-21

Shifts in Expenditures Might Reflect Desired Shifts

in Supply and Demand 26W-21

Expenditures Depend on Much More Than Current

Income 26W-21

Conclusion 26W-22

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 26W-22–26W-26

Appendix A: An Algebraic Presentation of the Expanded

Multiplier Model 26W-26

Appendix B: The Multiplier Model and the AS/AD

Model 26W-29

27 The Classical Long-Run Policy Model:

Growth and Supply-Side Policies 610

General Observations about Growth 611

Growth and the Economy’s Potential Output 611

The Benefits and Costs of Growth 613

The Importance of Growth for Living Standards 613

Markets, Specialization, and Growth 614

Economic Growth, Distribution, and Markets 615

Per Capita Growth 616

The Sources of Growth 617

Growth-Compatible Institutions 617

Investment and Accumulated Capital 618

Available Resources 620

Technological Development 621

Entrepreneurship 622

Turning the Sources of Growth into Growth 622

Capital and Investment 622

Technology 623

Growth Policies 626

xxvi Contents

coL25585_fm_i-xxxii_1.indd 26 11/24/18 11:03 AM

Contents xxvii

The Complex Nature of Monetary Policy 670

The Taylor Rule 672

Maintaining Policy Credibility 675

Conclusion 677

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 677–680

30 Financial Crises, Panics,

and Unconventional Monetary

Policy

681

The Central Bank’s Role in a Crisis 682

Anatomy of a Financial Crisis 683

The Financial Crisis: The Bubble Bursts 683

The Fed as the Lender of Last Resort 685

The Role of Leverage and Herding in a Crisis 686

Leverage 686

Herding 686

The Problem of Regulating the Financial Sector 687

Regulation, Bubbles, and the Financial Sector 689

The Law of Diminishing Control 690

General Principles of Regulation 693

Monetary Policy in the Post–Financial Crisis Era 693

Unconventional Monetary Policy 694

Conclusion 697

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 697–700

TAXES, BUDGETS, AND FISCAL POLICY

31 Deficits and Debt:

The Austerity Debate 701

Defining Deficits and Surpluses 702

Financing the Deficit 703

Arbitrariness of Defining Deficits and

Surpluses 703

Many Right Definitions 704

Deficits and Surpluses as Summary Measures 704

Structural and Cyclical Deficits and Surpluses 704

Nominal and Real Deficits and Surpluses 705

Defining Debt and Assets 707

Debt Management 708

Difference between Individual and

Government Debt 710

Conclusion 627

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 628–630

FINANCE, MONEY, AND THE ECONOMY

28 The Financial Sector and

the Economy 631

The Definition and Functions of Money 632

The U.S. Central Bank: The Fed 632

Functions of Money 633

Alternative Measures of Money 636

Distinguishing between Money and Credit 636

Banks and the Creation of Money 638

How Banks Create Money 639

The Process of Money Creation 641

The Relationship between Reserves

and Total Money 644

Faith as the Backing of Our Money Supply 644

Why Is the Financial Sector Important to Macro? 645

The Role of Interest Rates in the Financial Sector 645

Long- and Short-Term Interest Rates 647

The Demand for Money and the Role of the Interest

Rate 647

Why People Hold Money 647

The Many Interest Rates in the Economy 648

Conclusion 650

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 650–653

Appendix: A Closer Look at Financial Assets and

Liabilities 653

29 Monetary Policy 659

How Monetary Policy Works in the Models 659

How Monetary Policy Works in Practice 661

Monetary Policy and the Fed 661

Structure of the Fed 661

Duties of the Fed 664

The Tools of Conventional Monetary Policy 665

Open Market Operations 665

Reserves and the Money Supply 667

Borrowing from the Fed and the Discount Rate 669

The Fed Funds Market 669

coL25585_fm_i-xxxii_1.indd 27 11/24/18 11:03 AM

U.S. Government Deficits and Debt:

The Historical Record 710

The Debt Burden 711

U.S. Debt Relative to Other Countries 712

Interest Rates and Debt Burden 712

Conclusion 714

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 714–717

32 The Fiscal Policy Dilemma 718

Classical Economics and Sound Finance 719

Ricardian Equivalence Theorem: Deficits Don’t Matter 719

The Sound-Finance Precept 720

Keynesian Economics and Functional Finance 721

Assumptions of the AS/AD Model 722

Financing the Deficit Has No Offsetting Effects 722

The Government Knows the Situation 724

The Government Knows the Economy’s

Potential Income Level 724

The Government Has Flexibility in Changing

Spending and Taxes 725

The Size of the Government Debt

Doesn’t Matter 727

Fiscal Policy Doesn’t Negatively Affect

Other Government Goals 728

Summary of the Problems 728

Building Fiscal Policies into Institutions 728

How Automatic Stabilizers Work 728

State Government Finance and Procyclical Fiscal

Policy 729

The Negative Side of Automatic Stabilizers 731

Conclusion 731

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 733–735

MACROECONOMIC PROBLEMS

33 Jobs and Unemployment 736

The Debate about the Nature and Measurement of

Unemployment 738

Entrepreneurship and Unemployment 738

Microeconomic Categories of Unemployment 738

Unemployment and Potential Output 740

Is Unemployment Structural or Cyclical? 741

Why Has the Target Rate of Unemployment

Changed over Time? 742

Globalization, Immigration, and Jobs 743

Framing the Debate about Voluntary and

Involuntary Unemployment 744

Individual Responsibility and Unemployment 744

Social Responsibility and Unemployment 744

The Tough Policy Choices 745

Summary of the Debate 746

A Guaranteed-Job Proposal: Government as Employer

of Last Resort 746

The Design and Characteristics of the Program 747

Why Don’t the Guaranteed Jobs Do Something Useful? 748

Paying for the Program 749

Would Such a Plan Ever Be Implemented? 750

Conclusion 750

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues To Ponder, Answers

to Margin Questions 751–753

34 Inflation, Deflation, and Macro Policy 754

Defining Inflation 755

Asset Price Inflation and Deflation 755

The Costs and Benefits of Inflation 758

The Costs of Inflation 758

The Benefits of (Low) Inflation 760

The Danger of Accelerating Inflation 762

The Inflation Process and the Quantity

Theory of Money 763

Productivity, Inflation, and Wages 764

The Quantity Theory of Money and Inflation 764

The Declining Influence of the Quantity Theory 766

Inflation and the Phillips Curve Trade-Off 768

The Long-Run and Short-Run Phillips Curves 769

Global Competition and the Phillips Curve 771

Conclusion 772

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 772–776

INTERNATIONAL MACROECONOMIC

POLICY ISSUES

35 International Financial Policy 777

The Balance of Payments 777

The Current Account 779

xxviii Contents

coL25585_fm_i-xxxii_1.indd 28 11/24/18 11:03 AM

Contents xxix

Conclusion 816

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 816–819

37 Structural Stagnation and

Globalization 820

The Structural Stagnation Hypothesis 821

Why the Assumed Underlying Growth

Trend Is Important for Policy 821

Structural Stagnation as a Cause of the Slow

Recovery 824

Structural Stagnation’s Implications for Macro

Policy 824

Structural, Not Secular, Stagnation 825

The AS/AD Model with Globalization 826

Globalization Can Limit Potential Output 828

International Adjustment Forces 829

Why the Adjustments Did Not Occur 830

Aggregate Demand Increases No Longer

Cause Accelerating Inflation 830

Summary: Globalization and Structural

Imbalances 831

Structural Problems of Globalization 831

Structural Change in the Nontradable Sector 832

Globalization and Income Distribution 833

Remembering the Benefits of Globalization 835

The Future of Globalization 835

Policies to Deal with Structural Stagnation 836

Shifting the World Supply Curve Up 836

Shifting the Domestic SAS Curve Down 838

The Problems with the Standard Political

Solution 839

Conclusion 839

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 840–842

Appendix: Creating a Targeted Safety Net to Help the Least

Well Off 843

38 Macro Policy in Developing

Countries 845

Developing Countries in Perspective 846

Don’t Judge Society by Its Income Alone 847

Some Comparative Statistics on Rich and Poor

Nations 847

The Financial and Capital Account 780

What Is Meant by a Balance of Payments Deficit or

Surplus? 780

Exchange Rates 781

Fundamental Forces Determining Exchange Rates 782

Exchange Rate Dynamics 783

Influencing Exchange Rates with Monetary and Fiscal

Policy 785

The Problems of Determining the

Appropriate Exchange Rate 789

Purchasing Power Parity and Real Exchange Rates 789

Criticisms of the Purchasing Power Parity Method 791

Real Exchange Rates 791

Advantages and Disadvantages of

Alternative Exchange Rate Systems 792

Fixed Exchange Rates 792

Flexible Exchange Rates 793

Partially Flexible Exchange Rates 794

Which View Is Right? 795

Advantages and Disadvantages of a Common

Currency: The Future of the Euro 795

Conclusion 798

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 798–801

Appendix: History of Exchange Rate Systems 802

36 Macro Policy in a Global Setting 805

The Ambiguous International Goals of Macroeconomic

Policy 805

The Exchange Rate Goal 806

The Trade Balance Goal 806

International versus Domestic Goals 808

Balancing the Exchange Rate Goal with Domestic

Goals 808

Monetary and Fiscal Policy and the Trade Deficit 809

Monetary Policy’s Effect on the Trade Balance 809

Fiscal Policy’s Effect on the Trade Balance 810

International Phenomena and Domestic Goals 811

International Goals and Policy Alternatives 811

International Monetary and Fiscal Coordination 812

Coordination Is a Two-Way Street 812

Crowding Out and International Considerations 813

Globalization, Macro Policy, and

the U.S. Economy 813

International Issues and Macro Policy 814

Restoring International Trade Balance to the U.S.

Economy 815

coL25585_fm_i-xxxii_1.indd 29 11/24/18 11:03 AM

Growth versus Development 848

Differing Goals 849

Differing Institutions 849

Monetary Policy in Developing Countries 853

Central Banks Are Less Independent 853

Focus on the International Sector and the

Exchange Rate Constraint 855

The Need for Creativity 857

Obstacles to Economic Development 857

Political Instability 858

Corruption 859

Lack of Appropriate Institutions 860

Lack of Investment 860

Inappropriate Education 863

Overpopulation 865

Health and Disease 867

Conclusion 867

Summary, Key Terms, Questions and Exercises, Questions

from Alternative Perspectives, Issues to Ponder, Answers to

Margin Questions 867–870

Glossary G-1

Colloquial Glossary CG-1

Index I-1

xxx Contents

coL25585_fm_i-xxxii_1.indd 30 11/24/18 11:03 AM

xxxi

List of

Boxes

coL25585_fm_i-xxxii_1.indd 31 11/24/18 11:03 AM

REALWORLD APPLICATION

Winston Churchill and Lady Astor 12

Economists and Market Solutions 16

Economics and Climate Change 19

Made in China? 36

What Government Are We Talking About? 64

Uber, Lyft, and Taxi Pricing 110

Empirically Measuring Elasticities 136

Economists and the Debate about the Corporate

Income Tax 151

The Excess Burden of a Draft 155

Is It Time to Start Paying for Driving on Roads? 173

Climate Change, Global Warming, and Economic P

olicy 181

Hormones and Economics 216

Trump Trade Policy and Antiglobalization Forces 219

Transaction Costs and the Internet 231

Economies of Scale and 3D Printing 251

Travels of a T-Shirt and Economies of Scale 253

Holacracy, Diseconomies of Scale, and Zappos 254

Why Are Textbooks So Long? 256

The Internet and the Perfectly Competitive Model 275

The Shutdown Decision and the Relevant Costs 286

The Dark Side of Amazon 307

Strategic Competition between Uber and Lyft 326

Nefarious Business Practices 332

Why Are CEOs Paid So Much? 343

Branding 352

Are Humans Obsolete? 368

Why Do Women Earn Less Than Men? 375

From Welfare to Work 410

What Game Is Being Played? 450

Can You Explain Landsburg’

s Provocative Insights? 475

Can You Explain Frank’s Observations? 477

Markets as Information-Gathering Mechanisms 496

The Nudge Unit 502

Economists in the Courtroom 516

Where to Locate Polluting Industries 523

The Author’s Biases 538

NBER Dating of the Business Cycle 543

Gross Output: A New Revolutionary Way to Measure

the Economy? 562

The Underground Economy and Undocumented

Immigration 576

Growth and Terrorism 622

Short-Run Supply-Side Macro Policy 627

The Cryptocurrency Bubble

635

Characteristics of a Good Money 638

The Press and Present Value 656

Central Banks in Other Countries 663

Inside an FOMC Meeting 666

Will the Reserve Requirement Be Eliminated? 671

Cryptomania 692

Social Security and the U.S. Deficit 707

Fighting the Vietnam War Inflation 726

Austerity and the Greek Deficit Problem 730

Incentive and Supply-Side Effects of Public Finance 732

Categories of Unemployment 737

Previous Government Jobs Programs 749

Inflation, Nominal Income, and Asset

Inflation Targeting 769

The Exorbitant Privilege Puzzle 781

Iceland’s Monetary Woes 786

Determining the Causes of Fluctuations in

the Dollar’s Value 790

The U.S. Trade Deficit and the Value of the Dollar 807

Why Are the Structural Problems of Globalization So Much

Greater Now? 833

M-Pesa and Leapfrogging 852

A Real, Real-World Application: The Traditional Economy

Meets the Internet 853

Development and the Failure of the Doha Round 861

Sustainable Development Goals 864

ADDED DIMENSION

Economic Knowledge in One Sentence: TANSTAAFL 7

Economics in Perspective 10

Choices in Context: Decision Trees 31

The Developing Country’s Perspective on

Globalization 37

Tradition and Today’s Economy 56

Our International Competitors 67

The Supply and Demand for Children 94

Geometric Tricks for Estimating Price Elasticity 131

The Ambiguity of Total Surplus 146

Pareto Optimality and the Perfectly Competitive

Benchmark 166

xxxii List of Boxes

coL25585_fm_i-xxxii_1.indd 32 11/24/18 11:03 AM

Common Resources and the Tragedy of the Commons 169

Licensure and Surgery 179

International Issues in Perspective 211

Dumping 224

alue Added and the Calculation of Total

Production 232

A Trick in Graphing the Marginal Revenue Curve 296

Can Price Controls Increase Output and Lower Market

Price? 303

Monopolizing Monopoly 305

Normative Views of Monopoly 306

Who Controls Corporations? 342

Other Factors of Production 360

Income and Substitution Effects 362

Nonwage Income and Property Rights 373

The Gini Coefficient 396

What Should Be the Goal of Economic Policy? 404

Income Distribution Policy, Fairness, and the Takeaway

Principle 406

Making Stupid Decisions 430

Game Theory and Experimental Economics 448

The Segregation Game and Agent-Based Modeling 453

Neuroeconomics and Microeconomics 472

Karl Marx and Shove Policy 505

Economic Efficiency and the Goals of Society 520

Elasticity and Taxation to Change Behavior 522

The Conventional Policy Wisdom among Economists 526

The Power of Compounding 540

Alternative Measures of the Unemployment Rate 549

From Full Employment to the Target Rate of

Unemployment 551

Is GDP Biased against Women? 564

In the Long Run, We’re All Dead

585

Why Are Prices Inflexible? 593

Demand, Keynesian Economics, and Growth 612

Is Growth Good? 614

Is the 21st Century the Age of Technology or One of Many

Ages of Technology? 624

Interest Rates and the Price of Bonds 649

Do Financial Assets Make Society Richer? 657

How Independent Should the Central Bank Be? 664

Using the Money Multiplier in Practice 668

Generational Accounting 708

The Keeper of the Classical Faith: Milton Friedman 767

Business Cycles in History 822

What to Call Developing Countries 846

A REMINDER

Production Possibility Curves 29

Inverse and Direct Relationships 46

Six Things to Remember about a Demand Curve 85

Six Things to Remember about a Supply Curve 90

Supply and Demand in Action 103

A Review of Various Elasticity Terms 138

What Goods Should Be Taxed? 148

A Review of Costs 244

Finding Output, Price, and Profit 284

A Summary of a Perfectly Competitive Industry 287

Finding a Monopolist’s Output, Price, and Profit 299

A Comparison of Various Market Structures 327

Choices at the Margin 424

The Austan Goolsbee Check-a-Box Method for Finding

Dominant Strategies and Nash Equilibria 446

Modern Traditional and Behavioral Economists 485

A Review of the AS/AD Model 598

Some Limits of Fed Control 675

Conventional Wisdom about Conventional Monetary

Policy 676

Four Important Points about Deficits and Debt 713

Fundamental Forces and Exchange Rates 784

Monetary and Fiscal Policy’s Effect on International

Goals 813

THINKING LIKE A MODERN ECONOMIST

Why Do So Many Prices End in 99 Cents? 130

How to Get Students to Be Responsible 159

What “Goods” Do Firms Produce? The Costs of Producing

Image 238

Social Norms and Production 259

Profit Maximization and Real-World Firms 281

The Traditional Models as Stepping-Stones 417

Mental Accounting 428

Tulipmania, the South Sea Bubble, and Behavioral

Economics 684

coL25585_ch01_002-024.indd 04/10/18 4:01 PM 2

PART

Introduction:

Thinking Like an Economist

CHAPTER 1 Economics and Economic Reasoning

CHAPTER 2 The Production Possibility Model, Trade, and Globalization

CHAPTER 3 Economic Institutions

CHAPTER 4 Supply and Demand

CHAPTER 5 Using Supply and Demand

Part I is an introduction, and an introduction to an intro-

duction seems a little funny. But other sections have in-

troductions, so it seemed a little funny not to have an

introduction to Part I; and besides, as you will see, I’m a

little funny myself (which, in turn, has two interpreta-

tions; I’m sure you will decide which of the two is appro-

priate). It will, however, be a very brief introduction,

consisting of questions you may have had and some

answers to those questions.

Some Questions and Answers

Why study economics?

Because it’s neat and interesting and helps provide insight

into events that are constantly going on around you.

Why is this book so big?

Because there’s a lot of important information in it and

because the book is designed so your teacher can pick and

choose. You’ll likely not be required to read all of it,

especially if you’re on the quarter system. But once you

start it, you’ll probably read it all anyhow. (Would you

believe?)

Why does this book cost so much?

To answer this question, you’ll have to read the book.

Will this book make me rich?

No.

Will this book make me happy?

It depends.

This book doesn’t seem to be written in a normal textbook

style. Is this book really written by a professor?

Yes, but he is different. He misspent his youth working

on cars; he married his high school sweetheart after they

met again at their 20th high school reunion, and they re-

main happily married today, still totally in love. Twenty-

five years after graduating from high school, his wife

went back to medical school and got her MD because

shewas tired of being treated poorly by doctors. Their

five kids make sure he doesn’t get carried away in the

professorial cloud.

Will the entire book be like this?

No, the introduction is just trying to rope you in. Much of

the book will be hard going. Learning happens to be a

difficult process: no pain, no gain. But the author isn’t a

sadist; he tries to make learning as pleasantly painful as

possible.

What do the author’s students think of him?

Weird, definitely weird—and hard. But fair, interesting,

and sincerely interested in getting us to learn. (Answer

written by his students.)

So there you have it. Answers to the questions that

you might never have thought of if they hadn’t been put in

front of you. I hope they give you a sense of me and the

approach I’ll use in the book. There are some neat ideas

in it. Let’s now briefly consider what’s in the first five

chapters.

A Survey of the

First Five Chapters

This first section is really an introduction to the rest of the

book. It gives you the background necessary so that the

later chapters make sense. Chapter 1 gives you an over-

view of the entire field of economics as well as an intro-

duction to my style. Chapter 2 focuses on the production

possibility curve, comparative advantage, and trade. It

explains how trade increases production possibilities but

also why, in the real world, free trade and no government

regulation may not be the best policy. Chapter 3 gives you

some history of economic systems and introduces you

tothe institutions of the U.S. economy. Chapters 4 and

5introduce you to supply and demand, and show you

notonly the power of those two concepts but also the

limitations.

Now let’s get on with the show.

coL25585_ch01_002-024.indd 04/10/18 4:01 PM3

CHAPTER

Economics and

Economic Reasoning

coL25585_ch01_002-024.indd 10/5/18 4:23 PM

In my vacations, I visited the poorest quarters of

several cities and walked through one street after

another, looking at the faces of the poorest people.

Next I resolved to make as thorough a study as

Icould of Political Economy.

—Alfred Marshall

After reading this chapter,

you should be able to:

LO1-1 Define economics and

identify its components.

LO1-2 Discuss various ways in

which economists use

economic reasoning.

LO1-3 Explain real-world events in

terms of economic forces,

social forces, and political

forces.

LO1-4 Explain how economic

insights are developed

andused.

LO1-5 Distinguish among positive

economics, normative

economics, and the art

ofeconomics.

©Ingram Publishing

When an artist looks at the world, he sees color. When a musician looks at the

world, she hears music. When an economist looks at the world, she sees a sym-

phony of costs and benefits. The economist’s world might not be as colorful or

as melodic as the others’ worlds, but it’s more practical. If you want to under-

stand what’s going on in the world that’s really out there, you need to know

economics.

I hardly have to convince you of this fact if you keep up with the news.

You will be bombarded with stories of unemployment, interest r

ates, how

commodity prices are changing, and how businesses are doing. The list is

endless. So let’s say you grant me that economics is important. That still

doesn’t mean that it’s worth studying. The real question then is: How much

will you learn? Most of what you learn depends on you, but part depends on

the teacher and another part depends on the textbook. On both these counts,

Chapter 1 ■ Economics and Economic Reasoning 5

you’re in luck; since your teacher chose this book for your course, you must have a

super teacher.

What Economics Is

Economics is the study of how human beings coordinate their wants and desires, given

the decision-making mechanisms, social customs, and political realities of the society.

One of the key words in the definition of the term economics is coordination. Coordi-

nation can mean many things. In the study of economics, coordination refers to how

the three central problems facing any economy are solved. These central problems are:

1. What, and how much, to produce.

2. How to produce it.

3. For whom to produce it.

Three central coordination problems

any economy must solve are what to

produce, how to produce it, and for

whom to produce it.

How hard is it to make the three decisions? Imagine for a moment the problem of

living in a family: the fights, arguments, and questions that come up. “Do I have to do

the dishes?” “Why can’t I have piano lessons?” “Bobby got a new sweater. How come

I didn’t?” “Mom likes you best.” Now multiply the size of the family by millions. The

same fights, the same arguments, the same questions—only for society the questions

are millions of times more complicated. In answering these questions, economies find

that inevitably individuals want more than is available, given how much they’re will-

ing to work. That means that in our economy there is a problem of scarcity—the

goods available are too few to satisfy individuals’ desires.

The coordination questions faced by

society are complicated.

Scarcity

Scarcity has two elements: our wants and our means of fulfilling those wants. These

can be interrelated since wants are changeable and partially determined by society. The

way we fulfill wants can affect those wants. For example, if you work on Wall Street,

you will probably want upscale and trendy clothes. In Vermont I am quite happy wearing

Levi’s and flannel; in Florida I am quite happy in shorts.

The degree of scarcity is constantly changing. The quantity of goods, services, and

usable resources depends on technology and human action, which underlie production.

Individuals’ imagination, innovativeness, and willingness to do what needs to be done

can greatly increase available goods and resources. Who knows what technologies are

in our future—nanites or micromachines that change atoms into whatever we want

could conceivably eliminate scarcity of goods we currently consume. But they would

not eliminate scarcity entirely since new wants are constantly developing.

The quantity of goods, services,

and usable resources depends on

technology and human action.

So, how does an economy deal with scarcity? The answer is coercion. In all known

economies, coordination has involved some type of coercion—limiting people’s wants

and increasing the amount of work individuals are willing to do to fulfill those wants.

The reality is that many people would rather play than help solve society’s problems.

So the basic economic problem involves inspiring people to do things that other people

want them to do, and not to do things that other people don’t want them to do. Thus, an

alternative definition of economics is: the study of how to get people to do things

they’re not wild about doing (such as studying) and not to do things they are wild

coL25585_ch01_002-024.indd 5 04/10/18 4:01 PM

This book is written by a person, not a machine. That means that I have my quirks, my odd sense

of humor, and my biases. All textbook writers do. Most textbooks have the quirks and eccentricities

edited out so that all the books read and sound alike—professional but dull. I choose to sound like

me—sometimes professional, sometimes playful, and sometimes stubborn. In my view, that makes

the book more human and less dull. So forgive me my quirks—don’t always take me too seriously—

and I’ll try to keep you awake when you’re reading this book at 3 a.m. the day of the exam. If you

think it’s a killer to read a book this long, you ought to try writing one.

6 Introduction Thinking Like an Economist■

about doing (such as eating all the ice cream they like), so that the things some people

want to do are consistent with the things other people want to do.

Microeconomics and Macroeconomics

Economic theory is divided into two parts: microeconomic theory and macroeconomic

theory. Microeconomic theory considers economic reasoning from the viewpoint of indi-

viduals and firms and builds up to an analysis of the whole economy. Microeconomics is

the study of individual choice, and how that choice is influenced by economic forces.

Microeconomics studies such things as the pricing policies of firms, households’ deci-

sions on what to buy, and how markets allocate resources among alternative ends.

Microeconomics is the study of how

individual choice is influenced by

economic forces.

As we build up from microeconomic analysis to an analysis of the entire economy,

everything gets rather complicated. Many economists try to uncomplicate matters by taking

a different approach—a macroeconomic approach—first looking at the aggregate, or

whole, and then breaking it down into components. Macroeconomics is the study of the

economy as a whole. It considers the problems of inflation, unemployment, business cycles,

and growth. Macroeconomics focuses on aggregate relationships such as how household

consumption is related to income and how government policies can affect growth.

Macroeconomics is the study of the

economy as a whole. It considers the

problems of inflation, unemployment,

business cycles, and growth.

Consider an analogy to the human body. A micro approach analyzes a person by

looking first at each individual cell and then builds up. A macro approach starts with

the person and then goes on to his or her components—arms, legs, fingernails, feel-

ings, and so on. Put simply, microeconomics analyzes from the parts to the whole;

macroeconomics analyzes from the whole to the parts.

Q-1 Classify the following topics

asprimarily macroeconomic or

microeconomic:

1. The impact of a tax increase on

aggregate output.

2. The relationship between two

competing firms’ pricing behavior.

3. A farmer’s decision to plant soy or

wheat.

4. The effect of trade on economic

growth.

Microeconomics and macroeconomics are very much interrelated. What happens in

the economy as a whole is based on individual decisions, but individual decisions are

made within an economy and can be understood only within its macro context. For

example, whether a firm decides to expand production capacity will depend on what the

owners expect will happen to the demand for their products. Those expectations are

determined by macroeconomic conditions. Because microeconomics focuses on indi-

viduals and macroeconomics focuses on the whole economy, traditionally microeco-

nomics and macroeconomics are taught separately, even though they are interrelated.

A Guide to Economic Reasoning

People trained in economics think in a certain way. They analyze everything critically;

they compare the costs and the benefits of every issue and make decisions based on those

costs and benefits. For example, say you’re trying to decide whether a policy to eliminate

terrorist attacks on airlines is a good idea. Economists are trained to put their emotions

aside and ask: What are the costs of the policy, and what are the benefits? Thus, they are

open to the argument that security measures, such as conducting body searches of every

passenger or scanning all baggage with bomb-detecting machinery, might not be the

appropriate policy because the costs might exceed the benefits. To think like an econo-

mist involves addressing almost all issues using a cost/benefit approach. Economic rea-

soning also involves abstracting from the “unimportant” elements of a question and

focusing on the “important” ones by creating a simple model that captures the essence of

the issue or problem. How do you know whether the model has captured the important

elements? By collecting empirical evidence and “testing” the model—matching the

predictions of the model with the empirical evidence—to see if it fits. Economic

reasoning—how to think like a modern economist, making decisions on the basis of

costs and benefits—is the most important lesson you’ll learn from this book.

Economic reasoning is making decisions

on the basis of costs and benefits.

The book Freakonomics gives examples of the economist’s approach. It describes

a number of studies by University of Chicago economist Steve Levitt that unlock

coL25585_ch01_002-024.indd 6 04/10/18 4:01 PM

ADDED DIMENSION

Economic Knowledge in One Sentence: TANSTAAFL

Once upon a time, Tanstaafl was made king of all the

lands. His first act was to call his economic advisers and

tell them to write up all the economic knowledge the society

possessed. After years of work, they presented their mon-

umental effort: 25 volumes, each about 400 pages long.

But in the interim, King Tanstaafl had become a very busy

man, what with running a kingdom of all the lands and all.

Looking at the lengthy volumes, he told his advisers to

summarize their findings in one volume.

Despondently, the economists returned to their desks,

wondering how they could summarize what they’d

been so

careful to spell out. After many more years of rewriting, they

were finally satisfied with their one-volume effort and tried

to make an appointment to see the king. Unfortunately, af-

fairs of state had become even more pressing than before,

and the king couldn’t take the time to see them. Instead he

sent word to them that he couldn’t be bothered with a whole

volume, and ordered them, under threat of death (for he had

become a tyrant), to reduce the work to one sentence.

The economists returned to their desks, shivering in

their sandals and pondering their impossible task. Think-

ing about their fate if they were not successful, they de-

cided to send out for one last meal. Unfortunately, when

they were collecting money to pay for the meal, they dis-

covered they were broke. The disgusted delivery person

took the last meal back to the restaurant, and the econo-

mists started down the path to the beheading station. On

the way

, the delivery person’s parting words echoed in

their ears. They looked at each other and suddenly they

realized the truth. “We’re saved!” they screamed. “That’s it!

That’s economic knowledge in one sentence!” They wrote

down the sentence and presented it to the king, who

thereafter fully understood all economic problems. (He

also gave them a good meal.) The sentence?

There Ain’t No Such Thing As A Free Lunch—

TANSTAAFL

seemingly mysterious observations with basic economic reasoning. For example, Levitt

asked the question: Why do drug dealers on the street tend to live with their mothers?

The answer he arrived at was that they couldn’t afford to live on their own; most

earned less than $5 an hour. Why, then, were they dealing drugs and not working a

legal job that, even for a minimum wage job, paid over $7 an hour? The answer to that

is determined through cost/benefit analysis. While their current income was low, their

potential income as a drug dealer was much higher since, given their background and

existing U.S. institutions, they were more likely to move up to a high position in

thelocal drug business (and Freakonomics describes how it is a business) and earn a

six-figure income than they were to move up from working as a Taco Bell technician to

an executive earning a six-figure income in corporate America. Levitt’s model is a very

simple one—people do what is in their best interest financially—and it assumes that

people rely on a cost/benefit analysis to make decisions. Finally, he supports his argu-

ment through careful empirical work, collecting and organizing the data to see if they fit

the model. His work is a good example of “thinking like a modern economist” in action.

Economic reasoning, once learned, is infectious. If you’re susceptible, being

exposed to it will change your life. It will influence your analysis of everything, includ-

ing issues normally considered outside the scope of economics. For example, you will

likely use economic reasoning to decide the possibility of getting a date for Saturday

night, and who will pay for dinner. You will likely use it to decide whether to read this

book, whether to attend class, whom to marry, and what kind of work to go into after

you graduate. This is not to say that economic reasoning will provide all the answers.

As you will see throughout this book, real-world questions are inevitably complicated,

and economic reasoning simply provides a framework within which to approach a

question. In the economic way of thinking, every choice has costs and benefits, and

decisions are made by comparing them.

coL25585_ch01_002-024.indd 7 04/10/18 4:01 PM

8 Introduction ■ Thinking Like an Economist

Marginal Costs and Marginal Benefits

The relevant costs and relevant benefits to economic reasoning are the expected incre-

mental, or additional, costs incurred and the expected incremental benefits that result

from a decision. Economists use the term marginal when referring to additional or

incremental. Marginal costs and marginal benefits are key concepts.

A marginal cost is the additional cost to you over and above the costs you have

already incurred. That means not counting sunk costs—costs that have already been

incurred and cannot be recovered—in the relevant costs when making a decision.

Consider, for example, attending class. You’ve already paid your tuition; it is a sunk

cost. So the marginal (or additional) cost of going to class does not include tuition.

Web Note 1.1

Costs and Benefits

Similarly with marginal benefit. A marginal benefit is the additional benefit

abov

e what you’ve already derived. The marginal benefit of reading this chapter is the

additional knowledge you get from reading it. If you already knew everything in this

chapter before you picked up the book, the marginal benefit of reading it now is zero.

The Economic Decision Rule

Comparing marginal (additional) costs with marginal (additional) benefits will often

tell you how you should adjust your activities to be as well off as possible. Just follow

the economic decision rule:

If the marginal benefits of doing

something exceed the marginal costs,

do it. If the marginal costs of doing

something exceed the marginal

benefits, don’t do it.

If the marginal benefits of doing something exceed the marginal costs, do it.

If the marginal costs of doing something exceed the marginal benefits, don’t do it.

As an example, let’s consider a discussion I might have with a student who tells me that

she is too busy to attend my classes. I respond, “Think about the tuition you’ve spent for this

class—it works out to about $60 a lecture.” She answers that the book she reads for class is a

book that I wrote, and that I wrote it so clearly she fully understands everything. She goes on:

Q-2 Say you bought a share of

Oracle for $100 and a share of Cisco for

$10. The price of each is currently $15.

Assuming taxes are not an issue, which

would you sell if you needed $15?

I’ve already paid the tuition and whether I go to class or not, I can’t get any of the

tuition back, so the tuition is a sunk cost and doesn’t enter into my decision. The

marginal cost to me is what I could be doing with the hour instead of spending it

in class. I value my time at $75 an hour [people who understand everything value

their time highly], and even though I’ve heard that your lectures are super, I esti-

mate that the marginal benefit of attending your class is only $50. The marginal

cost, $75, exceeds the marginal benefit, $50, so I don’t attend class.

I congratulate her on her diplomacy and her economic reasoning, but tell her that I give

a quiz every week, that students who miss a quiz fail the quiz, that those who fail all the quiz-

zes fail the course, and that those who fail the course do not graduate. In short, she is under-

estimating the marginal benefits of attending my classes. Correctly estimated, the marginal

benefits of attending my class exceed the marginal costs. So she should attend my class.

Economics and Passion

Recognizing that everything has a cost is reasonable, but it’s a reasonableness that

many people don’t like. It takes some of the passion out of life. It leads you to consider

possibilities like these:

Web Note 1.2

Blogonomics

•

Saving some people’s lives with liver transplants might not be worth the

additional cost. The money might be better spent on nutritional programs that

would save 20 lives for every 2 lives you might save with transplants.

•

Maybe we shouldn’t try to eliminate all pollution because the additional cost

ofdoing so may be too high. To eliminate all pollution might be to forgo too

much of some other worthwhile activity.

Economic reasoning is based on the

premise that everything has a cost.

coL25585_ch01_002-024.indd 8 04/10/18 4:01 PM

Chapter 1 ■ Economics and Economic Reasoning 9

•

Providing a guaranteed job for every person who

wants one might not be a worthwhile policy goal if it

means that doing so will reduce the ability of an

economy to adapt to new technologies.

You get the idea. This kind of reasonableness is often

criticized for being coldhearted. But, not surprisingly, econ-

omists disagree; they argue that their reasoning leads to a

better society for the majority of people.

Economists’ reasonableness isn’t universally appreciated.

Businesses love the result; others aren’t so sure, as I discovered

some years back when my then-girlfriend told me she was leav-

ing me. “Why?,” I asked. “Because,” she responded, “you’re

so, so . . . reasonable.” It took me many years after she left to

learn what she already knew: There are many types of reason-

ableness, and not everyone thinks an economist’s reasonable-

ness is a virtue. I’ll discuss such issues later; for now, let me

simply warn you that, for better or worse, studying economics

will lead you to view questions in a cost/benefit framework.

Opportunity costs have always made choice difficult, as we

see in the early-19th-century engraving One or the Other.

©Heritage Images/Houlton Archive/Getty Images

coL25585_ch01_002-024.indd 9 04/10/18 4:01 PM

Opportunity Cost

Putting economists’ cost/benefit rules into practice isn’t easy. To do so, you have to be

able to choose and measure the costs and benefits correctly. Economists have devised the

concept of opportunity cost to help you do that. Opportunity cost is the benefit that you

might have gained from choosing the next-best alternative. To obtain the benefit of

something, you must give up (forgo) something else—namely, the next-best alternative.

The opportunity cost is the market value of that next-best alternative; it is a cost because

in choosing one thing, you are precluding an alternative choice. The TANSTAAFL story

in the earlier Added Dimension box embodies the opportunity cost concept because it

tells us that there is a cost to everything; that cost is the next-best forgone alternative.

Q-3 Can you think of a reason why

acost/benefit approach to a problem

might be inappropriate? Can you give

an example?

Let’s consider some examples. The opportunity cost of going out once with Natalie

(or Nathaniel), the most beautiful woman (attractive man) in the world, is the benefit

you’d get from going out with your solid steady, Margo (Mike). The opportunity cost

of cleaning up the environment might be a reduction in the money available to assist

low-income individuals. The opportunity cost of having a child might be two boats,

three cars, and a two-week vacation each year for five years, which are what you could

have had if you hadn’t had the child. (Kids really are this expensive.)

Opportunity cost is the basis of cost/

benefit economic reasoning; it is the

benefit that you might have gained from

choosing the next-best alternative.

Examples are endless, but let’s consider two that are particularly relevant to you: what

courses to take and how much to study. Let’s say you’re a full-time student and at the

beginning of the term you had to choose five courses. Taking one precludes taking some

other, and the opportunity cost of taking an economics course may well be not taking a

course on theater. Similarly with studying: You have a limited amount of time to spend

studying economics, studying some other subject, sleeping, or partying. The more time

you spend on one activity, the less time you have for another. That’s opportunity cost.

Notice how neatly the opportunity cost concept takes into account costs and bene-

fits of all other options and converts these alternative benefits into costs of the decision

you’re now making. One of the most useful aspects of the opportunity cost concept is

that it focuses on two aspects of costs of a choice that often might be forgotten—

implicit costs and illusionary sunk costs. Implicit costs are costs associated with a

decision that often aren’t included in normal accounting costs.

For example, in thinking about whether it makes sense to read this book, the next-

best value of the time you spend reading it should be one of the costs that y

ou consider.

Web Note 1.3

Opportunity Cost

ADDED DIMENSION

Economics in Perspective

All too often, students study economics out of context.

They’re presented with sterile analysis and boring facts to

memorize, and are never shown how economics fits into

the larger scheme of things. That’s bad; it makes econom-

ics seem boring—but economics is not boring. Every so

often throughout this book, sometimes in the appendixes

and sometimes in these boxes, I’ll step back and put the

analysis in perspective, giving you an idea from whence

the analysis sprang and its historical context. In educa-

tional jargon, this is called enrichment.

I begin here with economics itself.

First, its history: In the 1500s there were few universi-

ties. Those that existed taught religion,

Latin, Greek, phi-

losophy, history, and mathematics. No economics. Then

came the Enlightenment (about 1700), in which reasoning

replaced God as the explanation of why things were the

way they were. Pre-Enlightenment thinkers would answer

the question “Why am I poor?” with “Because God wills it.”

Enlightenment scholars looked for a different explanation.

“Because of the nature of land ownership” is one answer

they found.

Such reasoned explanations required more knowledge

of the way things were, and the amount of information ex-

panded so rapidly that it had to be divided or categorized

for an individual to have hope of knowing a subject. Soon

philosophy was subdivided into science and philosophy. In

the 1700s, the sciences were

split into natural sciences

and social sciences. The amount of knowledge kept increas-

ing, and in the late 1800s and early 1900s social science

itself split into subdivisions: economics, political science,

history, geography, sociology, anthropology, and psychol-

ogy. Many of the insights about how the economic system

work

ed were codified in Adam Smith’s The Wealth of

Nations, written in 1776. Notice that this is before econom-

ics as a subdiscipline developed, and Adam Smith could

also be classified as an anthropologist, a sociologist, a

political scientist, and a social philosopher.

Throughout the 18th and 19th centuries, economists such

as Adam Smith, Thomas Malthus, John Stuart Mill, David

Ricardo, and Karl Marx were more than economists; they

were social philosophers who covered all aspects of social

science. These writers were subsequently called Classical

economists. Alfred Marshall continued in that classical tradi-

tion, and his book, Principles of Economics, published in the

late 1800s, was written with the other social sciences much

in evidence. But Marshall also changed the questions econ-

omists ask; he focused on those questions that could be

asked in a graphical supply/demand framework.

This book falls solidly in the Marshallian tradition. It

presents economics as a way of thinking—as an engine of

analysis used to understand real-world phenomena. But

itgoes beyond Marshall, and introduces you to a wider

variety of models and thinking than the supply and demand

models that Marshall used.

Marshallian economics is primarily about policy, not

theory. It sees institutions as well as political and social di-

mensions of reality as important, and it shows you how

economics ties in to those dimensions.

coL25585_ch01_002-024.indd 10 04/10/18 4:01 PM

Often, it isn’t because it is an implicit, not normally measured cost. Similarly with

firms—owners often think that they are making a profit from a business, but if they

add the value of their time to their cost, which economists argue they should, then their

profit often becomes a loss. They might have earned more simply by taking a job

somewhere else. Implicit costs should be included in opportunity costs. Sunk costs,

however, are often included in making decisions, but should not be. These costs are

called illusionary sunk costs—costs that show up in financial accounts but that econo-

mists argue should not be considered in a choice because they are already spent. They

will not change regardless of what the person making the decision chooses. For exam-

ple, once you have bought a book (that can’t be resold), what you paid for that book is

sunk. Following economic reasoning, that sunk cost shouldn’t enter into your decision

on whether to read it. An important role of the opportunity cost concept is to remind

you that the costs relevant to decisions are often different from the measured costs.

The costs relevant to decisions are often

different from the measured costs.

The relevance of opportunity cost isn’t limited to your individual decisions. Oppor-

tunity costs are also relevant to government’s decisions, which affect everyone in

society. A common example is what is called the guns-versus-butter debate. The

Chapter 1 ■ Economics and Economic Reasoning 11

resources that a society has are limited; therefore, its decision to use those resources to

have more guns (more weapons) means that it will have less butter (fewer consumer

goods). Thus, when society decides to spend $50 billion more on an improved health

care system, the opportunity cost of that decision is $50 billion not spent on helping

the homeless, paying off some of the national debt, or providing for national defense.

Q-4 John, your study partner, has

just said that the opportunity cost of

studying this chapter is about 1/38 the

price you paid for this book, since the

chapter is about 1/38 of the book. Is he

right? Why or why not?

The opportunity cost concept has endless implications. It can even be turned upon itself.

For instance, thinking about alternatives takes time; that means that there’s a cost to being

reasonable, so it’s only reasonable to be somewhat unreasonable. If you followed that argu-

ment, you’ve caught the economic bug. If you didn’t, don’t worry. Just remember the oppor-

tunity cost concept for now; I’ll infect you with economic thinking in the rest of the book.

Economic Forces, Social Forces,

and Political Forces

The opportunity cost concept applies to all aspects of life and is fundamental to under-

standing how society reacts to scarcity. When goods are scarce, those goods must be

rationed. That is, a mechanism must be chosen to determine who gets what.

Q-5 Ali, your study partner, states

that rationing health care is immoral—

that health care should be freely

available to all individuals in society.

How would you respond?

Economic and Market Forces

Let’s consider some specific real-world rationing mechanisms. Dormitory rooms are

often rationed by lottery, and permission to register in popular classes is often rationed

by a first-come, first-registered rule. Food in the United States, however, is generally

rationed by price. If price did not ration food, there wouldn’t be enough food to go

around. All scarce goods must be rationed in some fashion. These rationing mecha-

nisms are examples of economic forces, the necessary reactions to scarcity.

When an economic force operates

through the market, it becomes a

market force.

One of the important choices that a society must make is whether to allow these

economic forces to operate freely and openly or to try to rein them in. A market force

is an economic force that is given relatively free rein by society to work through the

market. Market forces ration by changing prices. When there’s a shortage, the price

goes up. When there’s a surplus, the price goes down. Much of this book will be devoted

to analyzing how the market works like an invisible hand, guiding economic forces to

coordinate individual actions and allocate scarce resources. The invisible hand is the

price mechanism, the rise and fall of prices that guides our actions in a market.

Economic reality is controlled by

threeforces:

1. Economic forces (the invisible hand).

2. Social forces.

3. Political forces.

Social and Political Forces

Societies can’t choose whether or not to allow economic forces to operate—economic

forces are always operating. However, societies can choose whether to allow market forces

to predominate. Social forces—forces that guide individual actions even though those

actions may not be in an individual’s selfish interest, and political forces—legal direc-

tives that direct individuals’ actions—play a major role in deciding whether to letmarket

forces operate. Economic reality is determined by a contest among these various forces.

Let’s consider a historical example in which social forces prevented an economic

force from becoming a market force: the problem of getting a date for Saturday night

back when people actually dated (or called the pairing off of two individuals a “date”).

If a school (or a society) had significantly more heterosexual people of one gender than

the other (let’s say more men than women), some men would find themselves without a

date—that is, men would be in excess supply—and would have to find something else

to do, say study or go to a movie by themselves. An “excess supply” person could solve

the problem by paying someone to go out with him or her, but that would have changed

the nature of the date in unacceptable ways. It would be revolting to the person who

offered payment and to the person who was offered payment. That unacceptability is an

Social, cultural, and political forces can

play a significant role in the economy.

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REALWORLD APPLICATION

Winston Churchill and Lady Astor

There are many stories about Nancy Astor,

the first woman elected to Britain’s Parlia-

ment. A vivacious, fearless American woman,

she married into the English aristocracy and,

during the 1930s and 1940s, became a bright

light on the English social and political

scenes, which were already quite bright.

One story told about Lady Astor is that

she and Winston Churchill, the unorthodox

genius who had a long and distinguished

political career and who was Britain’s prime

minister during World War II, were sitting in a

pub having a theoretical discussion about

morality. Churchill suggested that as a

thought experiment Lady Astor ponder the

following question: If a man were to promise her a huge

amount of money—say a million pounds—for the privi-

lege, would she sleep with him? Lady Astor did ponder

the question for a while and finally answered, yes, she

Lady Astor

©Bettmann/Getty Images

would, if the money were guaranteed.

Churchill then asked her if she would sleep

with him for five pounds. Her response

was sharp: “Of course not. What do you

think I am—a prostitute?” Churchill re-

sponded, “We have already established that

fact; we are now simply negotiating about

price.”

One moral that economists might draw

from this story is that economic incentives, if

high enough, can have a powerful influence

on behavior. But an equally important moral

of the story is that noneconomic incentives

also can be very strong. Why do most people

feel it’s wrong to sell sex for money, even if

they might be willing to do so if the price were high

enough? Keeping this second moral in mind will signifi-

cantly increase your economic understanding of real-

world events.

Q-6 Your study partner, Joan, states

that market forces are always operative.

Is she right? Why or why not?

example of the complex social and cultural norms that guide and limit our activities.

People don’t try to buy dates because social forces prevent them from doing so.

Often political and social forces work together against the invisible hand. For exam-

ple, in the United States there aren’t enough babies to satisfy all the couples who desire

them. Babies born to particular sets of parents are rationed—by luck. Consider a group of

parents, all of whom want babies. Those who can, have a baby; those who can’t have one,

but want one, try to adopt. Adoption agencies ration the available babies. Who gets a baby

depends on whom people know at the adoption agency and on the desires of the birth

mother, who can often specify the socioeconomic background (and many other character-

istics) of the family in which she wants her baby to grow up. That’s the economic force in

action; it gives more power to the supplier of something that’s in short supply.

If our society allowed individuals to buy and sell babies, that economic force would

be translated into a mark

et force. The invisible hand would see to it that the quantity of

babies supplied would equal the quantity of babies demanded at some price. The market,

not the adoption agencies, would do the rationing.

Pairing habits of young adults have changed in ways that have made “dating” somewhat of a

historical social convention. The new social conventions that guide such pairing functions do not

eliminate the problem of excess individuals, but they do obscure it and create multiple dimensions

of “excess.” Thinking about how they do so is a useful exercise.

Even though it’s against the law, some babies are nonetheless “sold” on a semilegal market, also called

a gray market. Recently, the “market price” for a healthy baby was about $30,000. If selling babies were

legal (and if people didn’t find it morally repugnant to have babies in order to sell them), the price would

be much lower because there would be a larger supply of babies. (It was not against the law to sell

human eggs in the early 2000s, and one human egg was sold for $50,000. The average price was much

lower; it varied with donor characteristics such as SAT scores and athletic accomplishments.)

©Rachel Epstein/PhotoEdit

coL25585_ch01_002-024.indd 12 04/10/18 4:01 PM

Chapter 1 ■ Economics and Economic Reasoning 13

Most people, including me, find the idea of selling babies

repugnant. But why? It’s the strength of social forces reinforced

by political forces. One can think of hundreds of examples of

such social and political forces overriding economic forces.

What is and isn’t allowable differs from one society to

another. For example, in North Korea, many private businesses

are against the law, so not many people start their own busi-

nesses. In the United States, until the 1970s, it was against the

law to hold gold except in jewelry and for certain limited uses

such as dental supplies, so most people refrained from holding

gold. Ultimately a country’s laws and social norms determine

whether the invisible hand will be allowed to work.

People don’t charge friends

interest to borrow money.

©Syda Productions/Shutterstock

Social and political forces are active in all parts of your life.

You don’t practice medicine without a license; you don’t sell

body parts or certain addictive drugs. These actions are against the law. But many

people do sell alcohol; that’s not against the law if you have a permit. You don’t charge

your friends interest to borrow money (you’d lose friends); you don’t charge your chil-

dren for their food (parents are supposed to feed their children); many sports and media

stars don’t sell their autographs (some do, but many consider the practice tacky); you

don’t lower the wage you’ll accept in order to take a job from someone else (you’re no

scab). The list is long. You cannot understand economics without understanding the

limitations that political and social forces place on economic actions.

In summary, what happens in a society can be seen as the reaction to, and interac-

tion of, t

hree sets of forces: (1) economic forces, (2) political and legal forces, and

(3)social and cultural forces. Economics has a role to play in sociology and politics,

just as sociology and politics have roles to play in economics.

What happens in society can be seen

asa reaction to, and interaction of,

economic forces with other forces.

Using Economic Insights

Economic insights are based on generalizations, called theories, about the workings of

an abstract economy as well as on contextual knowledge about the institutional struc-

ture of the economy. In this book I will introduce you to economic theories and mod-

els. Theories and models tie together economists’ terminology and knowledge about

economic institutions. Theories are inevitably too abstract to apply in specific cases,

and thus a theory is often embodied in an economic model—a framework that places

the generalized insights of the theory in a more specific contextual setting—or in an

economic principle—a commonly held economic insight stated as a law or principle.

To see the importance of principles, think back to when you learned to add. You didn’t

memorize the sum of 147 and 138; instead, you learned a principle of addition. The

principle says that when adding 147 and 138, you first add 7 + 8, which you memo-

rized was 15. You write down the 5 and carry the 1, which you add to 4 + 3 to get 8.

Then add 1 + 1 = 2. So the answer is 285. When you know just one principle, you

know how to add millions of combinations of numbers.

Web Note 1.4

Hip Hop Economics

Theories, models, and principles are continually “brought to the data” to see if the

predictions of the model match the data. Increases in computing po

wer and new statis-

tical techniques have given modern economists a far more rigorous set of procedures

to determine how well the predictions fit the data than was the case for earlier econo-

mists. This has led to a stronger reliance on quantitative empirical methods in modern

economics than in earlier economics.

Modern empirical work takes a variety of forms. In certain instances, economists

study questions by running controlled laborat

ory experiments. That branch of economics

is called experimental economics—a branch of economics that studies the economy

coL25585_ch01_002-024.indd 13 10/5/18 4:25 PM

14 Introduction ■ Thinking Like an Economist

through controlled experiments. These include laboratory experiments—experiments

in which individuals are brought into a computer laboratory and their reactions to

various treatments are measured and analyzed; field experiments—experiments in which

treatments in the real world are measured and analyzed; computer experiments—

experiments in which simulated economies are created within the computer and results

of various policies are explored; and natural experiments—naturally occurring events

that approximate a controlled experiment where something has changed in one place

but has not changed somewhere else.

An example of a natural experiment occurred when New Jersey raised its minimum

wage and neighboring state Pennsylvania did not. Economists Alan Kruger and David

Card compared the effects on unemployment in both states and found that increases in

the minimum wage in New Jersey did not significantly affect employment. This led to

a debate about what the empirical evidence was telling us. The reason is that in such

natural experiments, it is impossible to hold “other things constant,” as is done in labo-

ratory and field experiments, and thus the empirical results in economics are more

subject to dispute.

While economic models are less general than theories, they are still usually too

general to apply in specific cases. Models lead to theorems (propositions that are

logically true based on the assumptions in a model). To arrive at policy precepts

(policy rules that conclude that a particular course of action is preferable), theo-

rems must be combined with knowledge of real-world economic institutions and

value judgments determining the goals for which one is striving. In discussing

policy implications of theories and models, it is important to distinguish precepts

from theorems.

Theories, models, and principles must

be combined with a knowledge of real-

world economic institutions to arrive at

specific policy recommendations.

Economic analysis changes as technology changes. In recent years, data availabil-

ity and computational power have increased exponentially, and this has changed the

way economists study problems. Economists fresh out of graduate school are much

more likely than older economists to “let the data speak,” which means to use comput-

ing power to look for stable statistical relationships in the data and then use those

relationships to guide their policy. Modern economists are highly involved with the

development of systems that can perform tasks that people previously believed

required human intelligence such as the ability to learn from the past, find meaning,

and reason, known as artificial intelligence and deep learning systems. In many ways,

the algorithmic approach to problems underlying these systems reflects economists’—

such as Herbert Simon and Friedrich von Hayek—theories of how an economy works

and how systems process information.

The Invisible Hand Theorem

Knowing a theory gives you insight into a wide variety of economic phenomena even

though you don’t know the particulars of each phenomenon. For example, much of

economic theory deals with the pricing mechanism and how the market operates to

coordinate individuals’ decisions. Economists have come to the following theorems:

When the quantity supplied is greater than the quantity demanded, price has a

tendency to fall.

When the quantity demanded is greater than the quantity supplied, price has a

tendency to rise.

Q-7 There has been a superb

growing season and the quantity

of tomatoes supplied exceeds the

quantity demanded. What is likely

tohappen to the price of tomatoes?

Using these generalized theorems, economists have developed a theory of markets

that leads to the further theorem that, under certain conditions, markets are efficient.

That is, the market will coordinate individuals’ decisions, allocating scarce resources

efficiently. Efficiency means achieving a goal as cheaply as possible. Economists call

coL25585_ch01_002-024.indd 14 04/10/18 4:01 PM

Chapter 1 ■ Economics and Economic Reasoning 15

this theorem the invisible hand theorem—a market economy, through the price

mechanism, will tend to allocate resources efficiently.

Theories, and the models used to represent them, are enormously efficient methods

of conveying information, but they’re also necessarily abstract. They rely on simplify-

ing assumptions, and if you don’t know the assumptions, you don’t know the theory.

The result of forgetting assumptions could be similar to what happens if you forget that

you’re supposed to add numbers in columns. Forgetting that, yet remembering all the

steps, can lead to a wildly incorrect answer. For example,

If you don’t know the assumptions, you

don’t know the theory.

147

+138

1,608 is wrong.

Knowing the assumptions of theories and models allows you to progress beyond

gut reaction and better understand the strengths and weaknesses of various economic

theories and models. Let’s consider a central economic assumption: the assumption

that individuals behave rationally—that what they choose reflects what makes them

happiest, given the constraints. If that assumption doesn’t hold, the invisible hand

theorem doesn’t hold.

Presenting the invisible hand theorem in its full beauty is an important part of any

economics course. Presenting the assumptions on which it is based and the limitations

of the invisible hand is likewise an important part of the course. I’ll do both through-

out the book.

Economic Theory and Stories

Economic theory, and the models in which that theory is presented, often developed as

a shorthand way of telling a story. These stories are important; they make the theory

come alive and convey the insights that give economic theory its power. In this book

Ipresent plenty of theories and models, but they’re accompanied by stories that provide

the context that makes them relevant.

Theory is a shorthand way of telling

astory.

At times, because there are many new terms, discussing theories takes up much of

the presentation time and becomes a bit oppressive. That’s the nature of the beast. As

Albert Einstein said, “Theories should be as simple as possible, but not more so.”

When a theory becomes oppressive, pause and think about the underlying story that

the theory is meant to convey. That story should make sense and be concrete. If you

can’t translate the theory into a story, you don’t understand the theory.

Economic Institutions

To know whether you can apply economic theory to reality, you must know about eco-

nomic institutions—laws, common practices, and organizations in a society that affect

the economy. Corporations, governments, and cultural norms are all examples of eco-

nomic institutions. Many economic institutions have social, political, and religious

dimensions. For example, your job often influences your social standing. In addition,

many social institutions, such as the family, have economic functions. I include any insti-

tution that significantly affects economic decisions as an economic institution because

you must understand that institution if you are to understand how the economy functions.

To apply economic theory to reality,

you’ve got to have a sense of economic

institutions.

Economic institutions sometimes seem to operate in ways quite different than eco-

nomic theory predicts. For example, economic theory says that prices are determined

by supply and demand. However, businesses say that they set prices by rules of

thumb—often by what are called cost-plus-markup rules. That is, a firm determines

what its costs are, multiplies by 1.4 or 1.5, and the result is the price it sets. Economic

coL25585_ch01_002-024.indd 15 04/10/18 4:01 PM

REALWORLD APPLICATION

Economists and Market Solutions

Economic reasoning is playing an

increasing role in government policy.

Consider the regulation of pollution.

Pollution became a policy concern in the

1960s as books such as Rachel Carson’s

Silent Spring were published. In 1970, in

response to concerns about the environ-

ment, the Clean Air Act was passed. It

capped the amount of pollutants (such as

sulfur dioxide, carbon monoxide, nitrogen

dioxides, lead, and hydrocarbons) that firms could emit.

This was a “command-and-control” approach to regulation,

which brought about a reduction in pollution, but also

brought about lots of complaints by firms that either found

the limits costly to meet or couldn’t afford to meet them

and were forced to close.

Enter economists. They proposed an alternative ap-

proach, called cap-and-trade, that achieved the same

overall reduction in pollution but at a lower overall cost. In

the plan they proposed, government still set a pollution

cap that firms had to meet, but it gave individual firms

some flexibility. Firms that reduced emissions by less than

the required limit could buy pollution permits from other

coL25585_ch01_002-024.indd 16 04/10/18 4:01 PM

©Design Pics/Kelly Redinger

firms that reduced their emissions by

more than their limit. The price of the

permits would be determined in an

“emissions permit market.” Thus, firms

that had a low cost of reducing pollution

would have a strong incentive to reduce

pollution by more than their limit in order

to sell these permits, or rights to pollute,

to firms that had a high cost of reducing

pollution and therefore could reduce

their pollution by less than what was required. The net re-

duction was the same, but the reduction was achieved at a

lower cost.

In 1990 Congress adopted economists’ proposal and

the Clean Air Act was amended to include tradable emis-

sions permits. An active market in emissions permits de-

veloped, and it is estimated that the tradable permit

program has lowered the cost of reducing sulfur dioxide

emissions by

$1 billion a year while, at the same time, re-

ducing emissions by more than half, to levels significantly

below the cap. Other cap-and-trade programs have devel-

oped as well. You can read more about the current state of

tradable emissions at www.epa.gov/airmarkets.

theory says that supply and demand determine who’s hired; experience suggests that

hiring is often done on the basis of whom you know, not by market forces.

These apparent contradictions have two complementary explanations. First, eco-

nomic the

ory abstracts from many issues. These issues may account for the differ-

ences. Second, there’s no contradiction; economic principles often affect decisions

from behind the scenes. For instance, supply and demand pressures determine what

the price markup over cost will be. In all cases, however, to apply economic theory to

reality—to gain the full value of economic insights—you’ve got to have a sense of

economic institutions.

Economic Policy Options

Economic policies are actions (or inaction) taken by government to influence eco-

nomic actions. The final goal of the course is to present the economic policy options

facing our society today. For example, should the government restrict mergers between

firms? Should it run a budget deficit? Should it do something about the international

trade deficit? Should it decrease taxes?

I saved this discussion for last because there’s no sense talking about policy options

unless you know some economic terminology, some economic theory, and some

thing

about economic institutions. Once you know something about them, you’re in a posi-

tion to consider the policy options available for dealing with the economic problems

our society faces.

Chapter 1 ■ Economics and Economic Reasoning 17

Policies operate within institutions, but policies also can influence the institutions

within which they operate. Let’s consider an example: welfare policy and the institu-

tion of the two-parent family. In the 1960s, the United States developed a variety of

policy initiatives designed to eliminate poverty. These initiatives provided income to

single parents with children, and assumed that family structure would be unchanged by

these policies. But family structure changed substantially, and, very likely, these poli-

cies played a role in increasing the number of single-parent families. The result was

the programs failed to eliminate poverty. Now this is not to say that we should not have

programs to eliminate poverty, nor that two-parent families are always preferable to

one-parent families; it is only to say that we must build into our policies their effect on

institutions.

To carry out economic policy effectively,

one must understand how institutions

might change as a result of the

economic policy.

Q-8 True or false? Economists

should focus their policy analysis on

institutional changes because such

policies offer the largest gains.

Objective Policy Analysis

Good economic policy analysis is objective; that is, it keeps the analyst’s value

judgments separate from the analysis. Objective analysis does not say, “This is the

way things should be,” reflecting a goal established by the analyst. That would

besubjective analysis because it would reflect the analyst’s view of how things

should be. Instead, objective analysis says, “This is the way the economy works,

and if society (or the individual or firm for whom you’re doing the analysis) wants

to achieve a particular goal, this is how it might go about doing so.” Objective

analysis keeps, or at least tries to keep, an individual’s subjective views—

valuejudgments—separate. That doesn’t mean that policy analysis involves no

value judgments; policy analysis necessarily involves value judgments. But an

objective researcher attempts to make the value judgments being used both trans-

parent and not his own, but instead value judgments an “impartial spectator” (using

Adam Smith’s terminology) would use.

To make clear the distinction between objective and subjective analysis, econ-

omists have divided economics into three categories: positive economics, norma-

tive economics, and the art of economics. Positive economics is the study of what

is, and how the economy works. It explores the pure theory of economics, and it

discovers agreed-upon empirical regularities, often called empirical facts. Eco-

nomic theorists then relate their theories to those facts. Positive economics asks

such questions as: How does the market for hog bellies work? How do price

restrictions affect market forces? These questions fall under the heading of eco-

nomic theory.

Positive economics is the study of what

is, and how the economy works.

As I stated above, economic theory does not provide definitive policy recommen-

dations. It is too abstract and makes too many assumptions that don’t match observed

behavior. In positive economic theory, one looks for empirical facts and develops

theorems—propositions that logically follow from the assumptions of one’s model.

Theorems and agreed-upon empirical facts are almost by definition beyond dispute

and serve as the foundation for economic science. But these theorems don’t tell us

what policies should be followed.

Q-9 John, your study partner, is a

free market advocate. He argues that

the invisible hand theorem tells us that

the government should not interfere

with the economy. Do you agree?

Whyor why not?

To decide on policy, economists integrate normative judgments with insights

from positive economics. Normative economics is the study of what the goals of the

economy should be. Normative economics asks such questions as: What should the

distribution of income be? What should tax policy be designed to achieve? In dis-

cussing such questions, economists must carefully delineate whose goals they are

discussing. One cannot simply assume that one’s own goals for society are society’s

goals. For example, let’s consider an ongoing debate in economics. Some econo-

mists are worried about climate change; they believe that high consumption in rich

societies is causing climate change and that the high consumption is a result of

Normative economics is the study

ofwhat the goals of the economy

should be.

coL25585_ch01_002-024.indd 17 10/5/18 4:25 PM

18 Introduction Thinking Like an Economist■

interdependent wants—people want something only because other people have it—

buthaving it isn’t necessarily making people happier. These economists argue that

society’s normative goal should include a much greater focus on the implications

ofeconomic activities for climate change, and the distribution of income, than is

currently the case. Discussion of these goals falls under the category of normative

economics.

In debating normative issues, economists defer to philosophers for guidance on

what the goals of society should be. But that hasn’t always been the case. The founder

of economics, Adam Smith, was himself a moral philosopher, and economic policy

analysis developed within a utilitarian moral philosophy that saw the normative goal

of policy as being “the greatest good for the greatest number.” This goal required

economists to consider policy in terms of the consequences of that policy, not on the

basis of its inherent morality. It also required them to consider policy not from a per-

spective that was good for any particular group, but from the perspective of a fair

composite of society. When conducting policy analysis they had to bend over back-

wards to maintain impartiality.

Focus on such impartiality led early economists to argue against both slavery and

the oppression of women at a time when those positions were highly unpopular and

seen as radical. It also led them to argue in favor of the significant coordination of

society by the market, which they felt would bring about greater happiness for a greater

number than would the alternative of significant government coordination. Their sup-

port of markets was based on their moral philosophy, not just their science.

Adam Smith was part of this moral tradition, and before he wrote his economic

treatise, The Wealth of Nations, he wrote a philosophical treatise, The Theory of Moral

Sentiments, which provided a normative foundation for his economics. In it, Smith cre-

ated a tool that he argued was useful in shedding light on what was meant by the vague

and somewhat contradictory “greatest good for the greatest number.” That tool was the

impartial spectator tool in which each person places himself in the position of a

third-person examiner and judges a situation from everyone’s perspective, not just his

own. Then, having done that, he does his best to come to a policy that he could argue

would achieve the greatest good for the greatest number.

To use the impartial spectator tool, each

person places himself in the position of

a third-person examiner and judges a

situation from everyone’s perspective,

not just his own

Economists did not expect people to arrive at definitive policy conclusions based

on this tool. But they did see the tool as providing a framework within which people

could discuss policy in terms of what was best for society as a whole, not what was

best for themselves, or their friends. This tool would focus arguments about policy on

their impact on people in the community, rather than on abstract debates about the

morality of policy, which generally led nowhere. That approach to morality was an

important part of policy economics, and was how economists moved from the theo-

rems developed in science to policy precepts.

Some economists hoped that they would be able to determine the goals of policy

scientifically, but they quickly decided that that was impossible. They came to

believe that utility—a general measure of people’s welfare used in policy analysis—

is neither scientifically measurable nor comparable between individuals. It is for that

reason that economic science does not lead to any particular policy conclusions. To

move to policy conclusions, one must supplement science with moral philosophical

insights developed in self-reflective considerations and heartfelt discussions with

others about what is meant by the greatest good for the greatest number. Policy

economists have to picture themselves as walking in the shoes of every person ever-

where, not just their own.

The art of economics, also called political economy, is the application of the

knowledge learned in positive economics to achieve the goals one has determined in

normative economics. It looks at such questions as: To achieve the goals that society

The art of economics is the application

of the knowledge learned in positive

economics to achieve the goals

determined in normative economics.

coL25585_ch01_002-024.indd 18 10/5/18 4:25 PM

REALWORLD APPLICATION

Economics and Climate Change

A good example of the central role that

economics plays in policy debates is the

debate about climate change. Almost all

scientists are now convinced that cli-

mate change is occurring and that hu-

man activity such as the burning of fossil

fuel is one of the causes. The policy

question is what to do about it. To an-

swer that question, most governments

have turned to economists. The first part

of the question that economists have

considered is whether it is worth doing anything, and in a

well-publicized report commissioned by the British gov-

ernment, economist Nicholas Stern argued that, based

upon his cost/benefit analysis, yes it is worth doing some-

thing. The reason: Because the costs of not doing any-

thing would likely reduce output by 20 percent in the

future, and those costs (appropriately weighted for when

they occur) are less than the benefits of policies that can

be implemented.

The second part of the question is: What policies to im-

plement? The policies he recommended were policies that

changed incentives—specifically, policies that raised the

costs of emitting greenhouse gases and decreased the

coL25585_ch01_002-024.indd 19 04/10/18 4:01 PM

©AP Photo/Alden Pellett

costs of other forms of production. Those

recommended policies reflected the

economist’s opportunity cost framework

in action: If you want to change the re-

sult, change the incentives that individu-

als face.

There is considerable debate about

Stern’s analysis—both with the way he

conducted the cost/benefit analysis and

with his policy recommendations. Such

debates are inevitable when the data are

incomplete and numerous judgments need to be made. I

suspect that these debates will continue over the coming

years with economists on various sides of the debates.

Economists are generally not united in their views about

complicated policy issues since they differ in their norma-

tive views and in their assessment of the problem and of

what politically can be achieved; that’s because policy is

part of the art of economics, not part of positive econom-

ics. But the framework of the policy debate about climate

change is the economic framework. Thus, even though

political forces will ultimately choose what policy is fol-

lowed, you must understand the economic framework to

take part in the debate.

wants to achieve, how would you go about it, given the way the economy works?

Most policy discussions fall under the art of economics. The art of economics branch

is specifically about policy; it is designed to arrive at precepts, or guides for policy.

Precepts are based on theorems and empirical facts developed in positive economics

and goals developed in normative economics. The art of economics requires econo-

mists to assess the appropriateness of theorems to achieving the normative goals in the

real world. Whereas once the assumptions are agreed upon, theorems derived from

models are not debatable, precepts are debatable, and economists that use the same

theorems can hold different precepts. For example, a model may tell us that rent con-

trols (a legal maximum on rent) will cause a shortage of housing. That does not mean

that rent controls are necessarily bad policies, since rent controls may also have some

desirable effects. The precept that rent controls are bad policy is based upon a judg-

ment about the importance of those other effects, and one’s normative judgments

This three-part distinction was made back in 1891 by a famous economist, John Neville Keynes,

father of John Maynard Keynes, the economist who developed macroeconomics. This distinction

was instilled into modern economics by Milton Friedman and Richard Lipsey in the 1950s. They,

however, downplayed the art of economics, which J. N. Keynes had seen as central to understanding

the economist’s role in policy. In his discussion of the scope and method of economics, Lionel

Robbins used the term political economy rather than Keynes’ term the art of economics.

Web Note 1.5

The Art of Economics

Q-10 Tell whether the following

fivestatements belong in positive

economics, normative economics,

orthe art of economics.

1. We should support the market

because it is efficient.

2. Given certain conditions, the market

achieves efficient results.

3. Based on past experience and our

understanding of markets, if one

wants a reasonably efficient result,

markets should probably be

reliedon.

4. The distribution of income should

beleft to markets.

5. Markets allocate income according

to contributions of factors of

production.

20 Introduction ■ Thinking Like an Economist

about the benefits and costs of the policy. In this book, when I say that economists tend

to favor a policy, I am talking about precepts, which means that alternative perspec-

tives are possible even among economists.

In each of these three branches of economics, economists separate their own

value judgments from their objective analysis as much as possible. The qualifier “as

much as possible” is important, since some value judgments inevitably sneak in. We

are products of our environment, and the questions we ask, the framework we use,

and the way we interpret the evidence all involve value judgments and reflect our

backgrounds.

Maintaining objectivity is easiest in positive economics, where you are working

with abstract models to understand how the economy works. Maintaining objectivity

is harder in normative economics. You must always be objective about whose norma-

tive values you are using. It’s easy to assume that all of society shares your values, but

that assumption is often wrong.

Maintaining objectivity is hardest in the art of economics because it can suffer

from the problems of both positive and normative economics. Because noneconomic

forces affect policy, to practice the art of economics we must make judgments about

how these noneconomic forces work. These judgments are likely to reflect our own

value judgments. So we must be exceedingly careful to be as objective as possible in

practicing the art of economics.

Policy and Social and Political Forces

When you think about the policy options facing society, you’ll quickly discover that

the choice of policy options depends on much more than economic theory. Politicians,

not economists, determine economic policy. To understand what policies are chosen,

you must take into account historical precedent plus social, cultural, and political

forces. In an economics course, I don’t have time to analyze these forces in as much

depth as I’d like. That’s one reason there are separate history, political science, sociology,

and anthropology courses.

While it is true that these other forces play significant roles in policy decisions,

specialization is necessary. In economics, we focus the analysis on the invisible

hand, and much of economic theory is devoted to considering how the economy

would operate if the invisible hand were the only force operating. But as soon as we

apply theory to reality and policy, we must take into account political and social

forces as well.

An example will make my point more concrete. Most economists agree that hold-

ing down or eliminating tariffs (taxes on imports) and quotas (numerical limitations on

imports) makes good economic sense. They strongly advise governments to follow a

policy of free trade. Do governments follow free trade policies? Almost invariably

they do not. Politics leads society in a different direction. If you’re advising a policy

maker, you need to point out that these other forces must be taken into account, and

how other forces should (if they should) and can (if they can) be integrated with your

recommendations.

Conclusion

Tons more could be said to introduce you to economics, but an introduction must

remain an introduction. As it is, this chapter should have:

Introduced you to economic reasoning.

2. Surveyed what we’re going to cover in this book.

3. Given you an idea of my writing style and approach.

coL25585_ch01_002-024.indd 20 04/10/18 4:01 PM

Chapter 1 ■ Economics and Economic Reasoning 21

We’ll be spending long hours together over the coming term, and before entering

into such a commitment it’s best to know your partner. While I won’t know you, by the

end of this book you’ll know me. Maybe you won’t love me as my mother does, but

you’ll know me.

This introduction was my opening line. I hope it also conveyed the importance and

relevance of economics. If it did, it has served its intended purpose. Economics is

tough, but tough can be fun.

Summary

•

The three coordination problems any economy must

solve are what to produce, how to produce it, and

forwhom to produce it. In solving these problems,

societies have found that there is a problem of

scarcity. (LO1-1)

•

Economics can be divided into microeconomics and

macroeconomics. Microeconomics is the study of

individual choice and how that choice is influenced

by economic forces. Macroeconomics is the study

ofthe economy as a whole. It considers problems

such as inflation, unemployment, business cycles,

andgrowth. (LO1-1)

•

Economic reasoning structures all questions in a

cost/benefit framework: If the marginal benefits of

doing something exceed the marginal costs, do it.

Ifthe marginal costs exceed the marginal benefits,

don’t doit. (LO1-2)

•

Sunk costs are not relevant in the economic decision

rule. (LO1-2)

•

The opportunity cost of undertaking an activity is the

benefit you might have gained from choosing the

next-best alternative. (LO1-2)

•

“There ain’t no such thing as a free lunch”

(TANSTAAFL) embodies the opportunity cost

concept. (LO1-2)

•

Economic forces, the forces of scarcity, are always

working. Market forces, which ration by changing

prices, are not always allowed to work. (LO1-3)

•

Economic reality is controlled and directed by three

types of forces: economic forces, political forces,

andsocial forces. (LO1-3)

•

Under certain conditions, the market, through its

pricemechanism, will allocate scarce resources

efficiently. (LO1-4)

•

Theorems are propositions that follow from the

assumptions of a model; precepts are the guides for

policies based on theorems, normative judgments,

andempirical observations about how the real world

differs from the model. (LO1-4)

•

Economics can be subdivided into positive economics,

normative economics, and the art of economics. Positive

economics is the study of what is, normative economics

is the study of what should be, and the art of economics

relates positive to normative economics. (LO1-5)

Key Terms

art of economics

economic decision rule

economic force

economic model

economic policy

economic principle

economics

efficiency

experimental economics

impartial spectator tool

implicit costs

invisible hand

invisible hand theorem

macroeconomics

marginal benefit

marginal cost

market force

microeconomics

normative economics

opportunity cost

political forces

positive economics

precepts

scarcity

social forces

sunk cost

theorems

coL25585_ch01_002-024.indd 21 04/10/18 4:01 PM

22 Introduction ■ Thinking Like an Economist

Questions and Exercises

1. Why does the textbook author focus on coordination

rather than on scarcity when defining economics?

(LO1-1)

2. State whether the following are primarily microeconomic

or macroeconomic policy issues: (LO1-1)

a. Should U.S. interest rates be lowered to decrease the

amount of unemployment?

b. Will the fact that more and more doctors are selling

their practices to managed care networks increase the

efficiency of medical providers?

c. Should the current federal income tax be lowered to

reduce unemployment?

d. Should the federal minimum wage be raised?

e. Should Sprint and Verizon both be allowed to build

local phone networks?

f. Should commercial banks be required to provide loans

in all areas of the territory from which they accept

deposits?

3. List two microeconomic and two macroeconomic

problems. (LO1-1)

4. Calculate, using the best estimates you can: (LO1-2)

a. Your opportunity cost of attending college.

b. Your opportunity cost of taking this course.

c. Your opportunity cost of attending yesterday’s lecture

in this course.

5. List one recent choice you made and explain why you

made the choice in terms of marginal benefits and

marginal costs. (LO1-2)

6. You rent a car for $29.95. The first 100 miles are free,

buteach mile thereafter costs 10 cents. You plan to

driveit 200 miles. What is the marginal cost of driving

the car? (LO1-2)

7. Economists Henry Saffer of Kean University, Frank J.

Chaloupka of the University of Illinois at Chicago, and

Dhaval Dave of Bentley College estimated that the gov-

ernment must spend $4,170 on drug control to deter one

person from using drugs and that the cost one drug user

imposes on society is $897. Based on this information

alone, should the government spend the money on drug

control? (LO1-2)

8. What is the opportunity cost of buying a $20,000

car? (LO1-2)

9. Suppose you currently earn $60,000 a year. You are con-

sidering a job that will increase your lifetime earnings by

$600,000 but that requires an MBA. The job will mean

also attending business school for two years at an annual

cost of $50,000. You already have a bachelor’s degree, for

which you spent $160,000 in tuition and books. Which of

the above information is relevant to your decision on

whether to take the job? (LO1-2)

10. Suppose your college has been given $5 million. You

havebeen asked to decide how to spend it to improve

yourcollege. Explain how you would use the economic

decision rule and the concept of opportunity costs to

decide how to spend it. (LO1-2)

11. Give two examples of social forces and explain how

theykeep economic forces from becoming market

forces. (LO1-3)

12. Give two examples of political or legal forces and

explain how they might interact with economic

forces. (LO1-3)

13. Individuals have two kidneys, but most of us need

onlyone. People who have lost both kidneys through

accident or disease must be hooked up to a dialysis

machine, which cleanses waste from their bodies. Say a

person who has two good kidneys offers to sell one of

them tosomeone whose kidney function has been totally

destroyed. The seller asks $30,000 for the kidney,

andthe person who haslost both kidneys accepts the

offer. (LO1-3)

a. Who benefits from the deal?

b. Who is hurt?

c. Should a society allow such market transactions?

Why?

14. What is an economic model? What besides a

modeldoeconomists need to make policy

recommendations? (LO1-4)

15. Does economic theory prove that the free market system

is best? Why? (Difficult) (LO1-4)

16. Distinguish between theorems and precepts.

Isit possible for two economists to agree about

theorems butdisagree about precepts? Why or why

not? (LO1-4)

17. What is the difference between normative and positive

statements? (LO1-5)

18. State whether the following statements belong in

positive economics, normative economics, or the art

ofeconomics. (LO1-5)

a. In a market, when quantity supplied exceeds quantity

demanded, price tends to fall.

b. When determining tax rates, the government

shouldtake into account the income needs of

individuals.

c. Given society’s options and goals, a broad-based tax

isgenerally preferred to a narrowly based tax.

d. California currently rations water to farmers at subsi-

dized prices. Once California allows the trading of

water rights, it will allow economic forces to be a

market force.

coL25585_ch01_002-024.indd 22 21/11/18 11:09 AM

Chapter 1 ■ Economics and Economic Reasoning 23

Questions from Alternative Perspectives

1. Is it possible to use objective economic analysis as a basis

for government planning? (Austrian)

2. In “Rational Choice with Passion: Virtue in a Model of

Rational Addiction,” Andrew M. Yuengert of Pepperdine

University argues that there is a conflict between reason

and passion.

a. What might that conflict be?

b. What implications does it have for applying the

economic model? (Religious)

3. Economic institutions are “habits of thought” that

organize society.

a. In what way might patriarchy be an institution and

how might it influence the labor market?

b. Does the free market or patriarchy better explain why

98 percent of secretaries are women and 98 percent of

automobile mechanics are men? (Feminist)

4. In October of 2004, the supply of flu vaccine fell by over

50percent when a major producer of the vaccine was shut

down. The result was that the vaccine had to be rationed,

with a priority schedule established: young children, people

with weakened immunity, those over 65, etc. taking priority.

a. Compare and contrast this allocation outcome with a

free market outcome.

b. Which alternative is more just? (Institutionalist)

5. The textbook model assumes that individuals have enough

knowledge to follow the economic decision rule.

a. How did you decide which college you would attend?

b. Did you have enough knowledge to follow the

economic decision rule?

c. For what type of decisions do you not use the

economic decision rule?

d. What are the implications for economic analysis if

most people don’t follow the economic decision rule

inmany aspects of their decisions? (Post-Keynesian)

6. Radical economists believe that all of economics, like all

theorizing or storytelling, is value-laden. Theories and

stories reflect the values of those who compose them

and tell them. For instance, radicals offer a different

analysis than most economists of how capitalism works

and what ought to be done about its most plaguing prob-

lems: inequality, periodic economic crises with large-

scale unemployment, and the alienation of the workers.

a. What does the radical position imply about the

distinction between positive economics and normative

economics that the text makes?

b. Is economics value-laden or objective and is the dis-

tinction between positive and normative economics

tenable or untenable? (Radical)

Issues to Ponder

1. At times we all regret decisions. Does this necessarily

mean we did not use the economic decision rule when

making the decision?

2. Economist Steven Landsburg argues that if one believes in

the death penalty for murderers because of its deterrent ef-

fect, using cost/benefit analysis we should execute computer

hackers—the creators of worms and viruses—because the

deterrent effect in cost saving would be greater than the de-

terrent effect in saving lives. Estimates are that each execu-

tion deters eight murders, which, if one valued each life at

about $7 million, saves about $56 million; he estimates that

executing hackers would save more than that per execution,

and thus would be the economic thing to do.

a. Do you agree or disagree with Landsburg’s argument?

Why?

b. Can you extend cost/benefit analysis to other areas?

3. Adam Smith, who wrote The Wealth of Nations, and who

isseen as the father of modern economics, also wrote The

Theory of Moral Sentiments. In it he argued that society

would be better off if people weren’t so selfish and were

more considerate of others. How does this view fit with the

discussion of economic reasoning presented in the chapter?

4. A Wall Street Journal article asked readers the following

questions. What’s your answer?

a. An accident has caused deadly fumes to enter the school

ventilation system where it will kill five children. You

can stop it by throwing a switch, but doing so will kill

one child in another room. Do you throw the switch?

b. Say that a doctor can save five patients with an organ

transplant that would end the life of a patient who is

sick, but not yet dead. Does she do it?

c. What is the difference between the two situations

described in a and b?

d. How important are opportunity costs in your decisions?

5. Economics is about strategic thinking, and the strategies

can get very complicated. Suppose Marge kisses Mike

and asks whether he liked it. She’d like Mike to answer

“yes” and she’d like that answer to be truthful. But Mike

knows that, and if he likes Marge, he may well say that he

liked the kiss even if he didn’t. But Marge knows that, and

thus might not really believe that Mike liked the kiss—

he’s just saying “yes” because that’s what Marge wants to

hear. But Mike knows that Marge knows that, so some-

times he has to convey a sense that he didn’t like it, so that

coL25585_ch01_002-024.indd 23 04/10/18 4:01 PM

24 Introduction ■ Thinking Like an Economist

Marge will believe him when he says that he did like it.

But Marge knows that . . . You get the picture.

Should you always be honest, even when it hurts

someone?

b. What strategies can you figure out to avoid the

problem of not believing the other person?

6. Go to two stores: a supermarket and a convenience store.

Write down the cost of a gallon of milk in each.

b. The prices are most likely different. Using the termi-

nology used in this chapter, explain why that is the

case and why anyone would buy milk in the store with

the higher price.

c. Do the same exercise with shirts or dresses in Walmart

(or its equivalent) and Saks (or its equivalent).

About 100,000 individuals in the United States are waiting

for organ transplants, and at an appropriate price many indi-

viduals would be willing to supply organs. Given those facts,

should human organs be allowed to be bought and sold?

8. Name an economic institution and explain how it affects

economic decision making or how its actions reflect

economic principles.

9. Tyler Cowen, an economist at George Mason University,

presents an interesting case that pits the market against legal

and social forces. The case involves payola—the payment of

money to disc jockeys for playing a songwriter’s songs. He

reports that Chuck Berry was having a hardtime getting his

music played because of racism. To counter this, he offered a

well-known disc jockey, Alan Freed, partial songwriting

credits, along with partial royalties, on any Chuck Berry

song of his choice. Freed chose Maybellene, which he played

and promoted. It went on to be a hit, Chuck Berry went on to

be a star, and Freed’s estate continues to receive royalties.

Should such payments be allowed? Why?

b. How did Freed’s incentives from the royalty payment

differ from Freed’s incentives if Chuck Berry had just

offered him a flat payment?

c. Name two other examples of similar activities—one

that is legal and one that is not.

10.

Name three ways a limited number of dormitory rooms

could be rationed. How would economic forces determine

individual behavior in each? How would social or legal

forces determine whether those economic forces become

market forces?

11. Prospect theory suggests that people are hurt more by

losses than they are uplifted by gains of a corresponding

size. If that is true, what implications would it have for

economic policy?

12.

Is a good economist always objective? Explain your answer.

13. Why are modern economists more likely to “let the data

speak” than are earlier economists?

Answers to Margin Questions

(1) Macroeconomics; (2) Microeconomics; (3) Microeco-

nomics; (4) Macroeconomics. (LO1-1)

2. Since the price of both stocks is now $15, it doesn’t mat-

ter which one you sell (assuming no differential capital

gains taxation). The price you bought them for doesn’t

matter; it’s a sunk cost. Marginal analysis refers to the

future gain, so what you expect to happen to future prices

of the stocks—not past prices—should determine which

stock you decide to sell. (LO1-2)

3. A cost/benefit analysis requires that you put a value on a

good, and placing a value on a good can be seen as de-

meaning it. Consider love. Try telling an acquaintance

that you’d like to buy his or her spiritual love, and see

what response you get. (LO1-2)

4. John is wrong. The opportunity cost of reading the chap-

ter is primarily the time you spend reading it. Reading the

book prevents you from doing other things. Assuming that

you already paid for the book, the original price is no

longer part of the opportunity cost; it is a sunk cost.

Bygones are bygones. (LO1-2)

5. Whenever there is scarcity, the scarce good must be

rationed by some means. Free health care has an

opportunity cost in other resources. So if health care is not

rationed, to get the resources to supply that care, other

goods would have to be more tightly rationed than they

currently are. It is likely that the opportunity cost of

supplying free health care would be larger than most

societies would be willing to pay. (LO1-3)

Joan is wrong. Economic forces are always operative;

market forces are not. (LO1-3)

7. According to the invisible hand theorem, the price of

tomatoes will likely fall. (LO1-4)

8. False. While such changes have the largest gain, they also

may have the largest cost. The policies economists should

focus on are those that offer the largest net gain—benefits

minus costs—to society. (LO1-5)

9. He is wrong. The invisible hand theorem is a positive theo-

rem and does not tell us anything about what policy to adopt.

To do so would be to violate Hume’s dictum that a “should”

cannot be derived from an “is.” This is not to say that gov-

ernment should or should not interfere; whether government

should interfere is a very difficult question. (LO1-5)

10. (1) Normative; (2) Positive; (3) Art; (4) Normative;

(5)Positive. (LO1-5)

Design elements: Web Note icon: ©McGraw-Hill Education; Real-World Application icon: ©McGraw-Hill Education; A Reminder icon: ©McGraw-Hill Education;

coL25585_ch01_002-024.indd 24 21/11/18 11:10 AM

CHAPTER

Financial Crises, Panics,

and Unconventional

Monetary Policy

It is well enough that people of the nation do not

understand our banking and monetary system, for if

they did, I believe there would be a revolution before

tomorrow morning.

—Henry Ford

After reading this chapter,

you should be able to:

LO30-1 Explain why financial crises

are dangerous and why

most economists see a

role for the central bank as

a lender of last resort.

LO30-2 Explain the role of leverage

and herding in financial

bubbles and how central

bank policy can contribute

to a financial bubble.

LO30-3 Explain why regulating

the financial sector and

preventing financial crises

is so difficult.

LO30-4 Discuss monetary policy in

the post–financial crisis

period.

coL25585_ch30_681-700.indd 681 04/12/18 10:47 AM

In 2008, the world financial system nearly stopped working. Banks were on the

verge of collapse, the stock market dropped precipitously, and the U.S. econ-

omy fell into a serious recession and possible structural stagnation. In response,

central banks and governments across the world took extraordinary steps—

buying banks, buying financial assets, guaranteeing deposits, and guaranteeing

loans to try to calm the crisis. Initially central banks thought that the problems

would be temporary, but after the initial short-term problems were handled,

longer-term problems emerged; economies throughout the world were faced

with sluggish growth and higher unemployment than they found acceptable,

and central banks feared that if they returned to conventional monetary policy,

the economies would crash. In response, what started as a highly unconven-

tional monetary policy became the new normal, with very low and even negative

interest rates, quantitative easing, and worry about inflation being too low, the

682 Macroeconomics ■ Finance, Money, and the Economy

new standard features of monetary policy. Only a decade later are central banks around

the world moving back to a more traditional monetary policy. In this chapter, we con-

sider unconventional monetary policy and the problems involved with unwinding it,

and moving back to a more conventional monetary policy. Specifically, we consider:

(1) financial panics and the Fed’s role as a lender of last resort, (2) the difficulty of

preventing financial crises and the structural problems they create, (3) the problems of

regulating the financial sector, and (4) the debate about unconventional monetary pol-

icies and how best to unwind them.

The Central Bank’s Role in a Crisis

Why is there so much concern about the financial sector and fear about a credit crisis?

Firms in the financial sector got themselves into this mess; they should get out of it on

their own. After all, the financial sector is only a small part of the entire economy. The

answer why is simple: We worry about the financial sector not because it is big or

small, but because all the other sectors need the financial sector to do business. While

oil is a relatively minor part of a working engine, it is absolutely essential. While the

failure of other big sectors such as the auto industry would be painful, it would not

bring all other sectors crashing down as a financial-sector collapse would. That’s why

one of the roles of a central bank is to be a lender of last resort—lending to banks and

other financial institutions when no one else will.

Q-1 Why do we worry about the

financial sector more than the

automobile sector?

When credit is not available, the real economy can quickly come to a halt. It’s not

like the slow effect of a contractionary demand shock. It is fast, like a heart attack. The

fear in October 2008 was that the financial crisis on Wall Street could cause the entire

economy to seize, spreading the problem from Wall Street (the financial sector) to

Main Street (the real sector), creating not a recession but a depression like the Great

Depression of the 1930s.

Think about what would happen if your credit dried up. Say that even though

you’re every bit as trustworthy as before, you suddenly find you can no longer borrow

money. No more spending with a credit card. Paying for some of your expenses might

still work just fine—you could buy groceries with cash at the local grocery store. Oth-

ers would be more difficult. Without credit, you’d have to pay all your bills before you

get the product. No more loans to buy a car; you’ll have to save $20,000 first. No more

checks since businesses couldn’t be assured the check would clear. Some things would

be downright impossible; forget about buying anything on the Internet. Paying for col-

lege? No problem . . . if you’ve already saved up enough to pay up front and in full.

Credit is a necessary part of the U.S.

economy.

The situation is even worse for companies. While they might not use credit cards,

just like you, they borrow for their short-term needs, such as buying the raw materials

for production and paying their workers. If their credit line disappears, companies

would essentially be forced to close because they couldn’t pay their workers. When

workers lose their jobs, they will cut their spending, causing other workers to lose their

jobs as well. A downward spiral of output will result. That’s why a severe financial

crisis can bring the entire real economy to a halt.

Luckily that didn’t happen. As soon as the crisis hit, the Fed put aside its standard

cautious approach to monetary policy and undertook a wide variety of unprecedented

actions. It acted as the lender of last resort—providing loans to financial institutions

that it determined were solvent—having sufficient assets to cover their long-run

liabilities—but were not sufficiently liquid—having assets that could readily be

converted into cash and money at non-fire-sale prices. Without liquid assets banks

couldn’t pay their short-run liabilities, such as interest on money they had borrowed.

In the financial crisis, the Fed acted as a

lender of last resort loaning to solvent,

but illiquid banks.

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Chapter 30 ■ Financial Crises, Panics, and Unconventional Monetary Policy 683

To prevent a financial collapse, the Fed took the banks’ long-run illiquid assets such

as mortgages, business loans, and Treasury bonds as collateral, and loaned the banks

money to pay their short-run liabilities. By doing so the Fed provided liquidity to the

financial market.

Similarly, the Treasury dropped all its standard practices and bailed out financial

firms, and Congress instituted strong expansionary fiscal policy. The hope was that

such actions would be enough to prevent the financial meltdown that would turn a seri-

ous recession into a second Great Depression. The policy succeeded; the United States

and world economies avoided a financial meltdown.

Anatomy of a Financial Crisis

Even though every financial crisis is different, all generally have similar elements and

2008 was no exception. A financial crisis begins with the creation of an asset price

bubble—unsustainable rapidly rising prices of some type of asset (such as stocks or

houses). Price increases in a bubble are unsustainable because they do not reflect an

increase in the real productive value of the asset. In the early 2000s, the bubble was in

the housing market.

A bubble is an unsustainable rapidly

rising price of some type of asset.

The key to a bubble is extrapolative expectations—expectations that a trend

will accelerate. It works like this: Initially, the market experiences a shock, which

causes prices to rise. In a standard aggregate supply/aggregate demand model, the

initial rise in price is the end of the story. The rise in prices brings the market back

into equilibrium. But in a financial bubble, the initial rise in price leads people to

expect further price increases. In anticipation of these price increases, people buy

goods and assets, causing aggregate demand to shift out to the right, which leads

prices to rise further, fulfilling expectations, and people to expect even more price

increases. In a bubble, expectations feed back on themselves, and prices rapidly

spiral upward. This is how it works:

Web Note 30.1

Bubble Analysis

In a bubble, expectations feed back on

themselves, and prices rapidly spiral

upward.

Rise in price → Expectations of a further rise in price → Rise in demand at the

current price → Rise in price → Expectations of a further rise in price . . . and so on

The Financial Crisis: The Bubble Bursts

In 2005, after rising precipitously for a number of years, housing

prices started to level off. Most standard economists talked about

prices settling into a permanently high plateau. But by 2006 hous-

ing prices began to fall precipitously—and it became clear that the

boom in housing prices in the early 2000s had been a financial bub-

ble. As soon as that was recognized, the bubble burst and everyone

wanted to get out of housing and housing-related assets before the

price of their houses fell further.

The bursting of the bubble involves the same process that

leads to the bubble—extrapolative expectations; it just works in

reverse. The price stops rising, which reverses the expectations

of rising prices into falling prices. People begin selling their

assets, which leads prices to fall even more. People expect prices

to fall even further, which leads more people to sell . . . and so

on. Those whose loans exceeded the value of their assets (commonly called being

underwater) are forced to sell or to default on their loans. Those defaults lead to

expectations of further price declines, which bring about further defaults.

The bursting of a bubble involves the

same process that leads to the bubble—

extrapolative expectations; it just works

in reverse.

Foreclosures rose considerably after the housing

bubble burst in 2006.

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684 Macroeconomics ■ Finance, Money, and the Economy

Thinking Like a Modern Economist

Tulipmania, the South Sea Bubble, and Behavioral Economics

Financial bubbles have been a fixture in economies

for centuries. Two of the most famous financial bub-

bles are Tulipmania and the South Sea bubble.

The height of Tulipmania occurred in Holland

between November 1636 and February 1637. It cen-

tered on, you guessed it, tulips—a relatively newly

introduced popular flower. Over three months, tulip

bulb prices are estimated to have risen by several

thousand percent, all without any

tulips actually changing hands—tulips

don’t even grow between November

and February. Instead, speculators

tried to make money by buying and

reselling promises to deliver tulip

bulbs the following May, after they

had flowered. Contracts for some

particularly rare bulbs were report-

edly trading for prices equivalent to

20 years of a typical workman’s

wages, and for a full 12 acres of land.

Trading was purely speculative; peo-

ple bought tulip contracts with the full

intention of “flipping” them for a profit

well before May. The bubble burst in

February when people realized that

at the current prices, no one would

be willing to pay the outrageous

prices for an actual tulip.

Another financial bubble was the

South Sea bubble of the early 1700s.

The South Sea bubble started when

rumors spread that the South Sea

Company—a company granted a monopoly on trade

with South American colonies by the British govern-

ment—would be enormously profitable. When the

stock price of the South Sea Company doubled, oth-

ers noticed and wanted to get in on the profit, push-

ing the price up further. The price of its stock rose

almost tenfold between January and August of 1720.

(The rise was helped along by various shady dealings

between the company and members of the British

Parliament.)

coL25585_ch30_681-700.indd 684 11/10/18 11:35 AM

Source: Reprint of 1841/1852 editions of

Extraordinary Popular Delusions and the

Madness of Crowds by Charles Mackay,

LL.D.

How could people afford to buy this stock at such

high prices? They borrowed and were allowed to

leverage their purchases. (Pay me 10 percent now

and the remaining 90 percent next week.) As long as

the stock price was rising, that wasn’t a problem.

When it was time to pay the remaining 90 percent,

the stockholder could sell the stock at a higher price,

repay the loan, and pocket the difference.

But then, suddenly, the rumors

reversed. The stock prices started

falling and everyone called in their

loans. To pay their loans, people tried

to sell stock that no one wanted to

buy; stock prices plummeted and the

bubble burst even more quickly than

it had formed.

Behavioral economics and standard

economics explain these bubbles dif-

ferently. Standard economics works

hard to provide a rational explanation

for financial bubbles. It has a theory of

what might be called rational bubbles.

For example, some economists have

argued that the high prices of tulips

and of South Sea Company stock were

plausible in light of the scarcity and

novelty of certain bulbs and imperfect

information about the profitability of

trade with the Americas. If bubbles are

rational, they should be considered an

unavoidable aspect of modern society.

Modern behavioral economists

disagree. They argue that bubbles form precisely

because people aren’t fully rational in the way that

economists define rationality—they are subject to

herd mentality. That is, they are predictably irrational.

Moreover, economists argue that in an unpredictable

world, there is no one rational course of action, and

the future is always in some sense unknown. This

difference is important because if behavioral econo-

mists are right, then there is a potential role for policy

to reduce the severity and occurrence of bubbles.

Chapter 30 ■ Financial Crises, Panics, and Unconventional Monetary Policy 685

Compared with the stock market crash of 1929, in 2007 housing prices declined

slowly. While financial assets can be sold quickly—at the click of a mouse—houses

cannot. Houses generally are listed with a real estate agent; buyers look at a number of

houses before deciding; then the price is negotiated. Even when people are not paying

their mortgage, banks can’t just kick people out of their houses; they must foreclose,

and that process can take years.

Despite all the difficulties with the housing market, the financial crisis was not

directly precipitated by the housing market crisis. It was a crisis in the market for

mortgage-backed securities. Mortgage-backed securities are securities that are

derivatives of mortgages in which thousands of mortgages are packaged with other

mortgages into a bundle of mortgages and sold on the securities market. These securi-

ties are related to housing because their value depends on the value of mortgages,

which in turn depends on the ability of homeowners to pay their mortgages, which in

turn depends on housing prices.

When the housing market crashed and people stopped paying their mortgages,

these mortgage-backed securities lost much of their value. Panic ensued because, like

homeowners who had borrowed significant sums to buy their houses, many financial

institutions had purchased these securities with mostly borrowed money. Some used

leverage—the practice of buying an asset with borrowed money—to buy those securi-

ties and were leveraged at a 30-to-1 ratio, which meant that for every dollar they

invested, they had borrowed $30. As the market for mortgage-backed securities dried

up, the banks found themselves in a pickle. Those financial institutions that had loaned

money to banks wanted their cash, and the banks didn’t have it. They had assets to pay

their lenders; they just weren’t liquid. They didn’t have sufficient time to sell those

assets and didn’t want to have to sell them at fire-sale prices. In economic jargon, the

banks were illiquid, not insolvent. That means that at non-fire-sale prices the banks

had sufficient assets to meet their long-term obligations but they didn’t have funds to

meet their short-term obligations. Without some source of liquidity, they would all go

bankrupt. Without liquidity banks stopped lending, and the economy started falling

into a recession. To prevent that recession from turning into a depression, the Fed

stepped in as lender of last resort.

Leverage is the practice of buying an

asset with borrowed money.

The Fed as the Lender of Last Resort

The Fed engaged in a type of financial triage—taking care of the most damaged

banks with emergency measures, doing whatever it could to keep people and firms

buying and selling securities. The Fed and the U.S. government took unprece-

dented actions to try to prevent a modern version of the “bank run” that had thrown

the U.S. economy into the Great Depression of the 1930s. Ben Bernanke, the chair

of the Fed, knew what could happen—he’d studied the 1930s and saw the paral-

lels. Fearing the worst, he put aside all conventional monetary theory and policy,

and started financial triage to prevent a complete meltdown of the U.S. financial

system.

The specifics were hotly debated; some economists and policy makers felt it was

too much, others felt it was too little, but just about all agreed that a policy in which the

Fed acts as the lender of last resort is good in principle. The important point is that all

these policies were emergency policies and have to be seen as such. Their goal was

clear—to prevent a financial meltdown. The political consensus was based on general

agreement that a financial meltdown would throw the economy into a depression. (We

will discuss problems with these emergency policies below.)

Just about all economists agreed that a

policy in which the Fed acts as the

lender of last resort is good in principle.

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686 Macroeconomics ■ Finance, Money, and the Economy

The Role of Leverage and Herding in a Crisis

Financial bubbles are important in a discussion of Fed policy because bubbles are

most likely to occur when credit—financial instruments for borrowing—is easily

available. With easily available credit people can borrow to invest, increasing leverage.

The larger the percentage bought with borrowed funds, the larger the leverage. The

reason Fed policy is important to bubbles is that the Fed significantly influences credit

availability in an economy. So while the Fed’s quick action in dealing with the finan-

cial crisis is laudable, it may very well have played a significant part in creating the

bubble in the first place.

While the Fed’s quick action in dealing

with the financial crisis is laudable, it

may very well have played a significant

part in creating the bubble in the first

place.

Leverage

To understand the power of leverage, consider the decision of a person buying a stock.

Say you can buy a share of stock at $2 and you believe that its price will rise to $3

within a year. If you sell the stock after its price rises, you will earn a 50 percent

return. While a 50 percent return is pretty good, if you use leverage, you can do even

better. What if instead of buying a single $2 stock, you borrow $198 at 10 percent

interest and buy 100 shares for $200? When the stock price goes up to $3, you could

sell your stock for $300, pay back the $198 you borrowed plus $19.80 in interest, leav-

ing you with a profit of $80.20—about a 4,000 percent return! That’s the power of

leverage. When you can expect returns like that, why hold back? You’d want to get as

much money into the stock market as possible. With everyone buying more stocks,

their prices rise, and rise, and rise, very quickly.

Leverage works with all assets and is a central part of any bubble. Bubbles can

happen in houses, mortgages, bonds, paintings, baseball cards, antiques—you name it.

As long as the price is rising more than the rate of interest at which you can borrow,

leverage is a way to get rich quickly. Because expansionary monetary policy increases

the degree of leverage in the economy both by lowering interest rates and by making

credit more easily available, monetary policy can encourage the development of a

financial bubble.

Leverage works with all assets and is a

central part of any bubble.

Leverage contributes to a bubble by increasing the ability of people to finance the

purchase of goods, services, and financial instruments, despite what might otherwise

seem like high prices. It is here where the debate about potential output described in a

previous chapter comes in. In the standard macro model, which uses goods price rises

as a signal to estimate potential output, until an economy experiences rising inflation,

the economy is seen as not exceeding potential output. Because inflation remained low

throughout the early 2000s, the Fed increased the money supply substantially—far

more than suggested by the standard Taylor rule, as described in the previous chapter,

and far far more than would be needed if the economy were in a structural stagnation.

Both the Taylor rule and economists who believed the economy was experiencing

structural stagnation suggested that much tighter monetary policy in the early 2000s

was needed. What led the Fed to increase the money supply was the fact that increases

in the money supply did not push up goods prices, since they were held down by world

prices. Instead it made the U.S. economy awash in credit, which allowed enormous

increases in leverage in financial markets.

Leverage contributes to a bubble by

increasing the ability of people to

finance the purchase of goods, services,

and financial instruments, despite what

might otherwise seem like high prices.

Herding

The other part of the formation of a financial bubble involves what psychologists and

behavioral economists call herding. Herding is the human tendency to follow the

crowd. When people around you see how much others are profiting by buying and sell-

ing assets, they want to profit too. They become convinced that the price of the asset is

Q-2 What are two central

ingredients to the development of

a financial bubble?

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Chapter 30 ■ Financial Crises, Panics, and Unconventional Monetary Policy 687

going to rise. When that happens, everyone buys more of the asset on credit, which

increases economywide risk enormously. That’s what happened in the housing market

in the 2000s.

Through the middle of the first decade of the 2000s, times were good in the housing

and construction markets, with housing prices rising nationally at historically high

rates. Flip That House and similar TV programs showcased people making tens of

thousands of dollars by buying a house with very little or no down payment, and

selling that house with enormous profit just months later. It seemed as if you could get

rich quick just by owning a house. Low interest rates and innovative mortgages

(mortgages with zero down payment and no proof of income or creditworthiness)

meant people who previously couldn’t qualify for a mortgage could buy houses. Some

people bought five or six houses, which they couldn’t afford, but which they planned

to sell before they had to repay the mortgage.

Web Note 30.2

Herding Tendencies

Homeownership rates rose to historic highs of nearly 70 percent. The feeling was

that you simply couldn’t lose on buying a house as an investment. As long as house

prices kept rising, flipping houses and stretching into a mortgage made sense. With

rising housing prices, people felt more wealthy—spending more and saving less

because their “houses were their savings.” When the value of your house is rising by

$30,000 a year, you can take out a home equity loan. Whether you save an extra $1,000

or not doesn’t seem all that important. All these actions increased the risk of signifi-

cant problems occurring in the economy if housing prices didn’t continue to rise, and

left the economy vulnerable to the housing bubble bursting.

But that’s not all. Leverage by homeowners was nothing compared with the

leverage in the financial sector built on top of the housing market. As mentioned

previously, investment banks and hedge funds had figured out how to create securities

whose values were linked to the performance of these mortgages. These securities

were leveraging the already highly leveraged mortgages, creating a financial asset built

on double—and in many cases even triple or quadruple—leverage.

Excess leverage played a major role in

the financial crisis.

When the financial bubble burst, the U.S. economy was on the verge of a financial

meltdown. Luckily, that didn’t happen. By 2009 and 2010, it was clear that the U.S.

economy had avoided a financial meltdown, but the economy wasn’t in good shape.

While it wasn’t in a depression, it was stagnating. Unemployment was about 10 percent

and growth was anemic.

With the threat of a financial meltdown out of the way, economists turned to other

issues: Why had the financial system come so close to failing? Why didn’t existing

regulations prevent the asset price bubble? What new regulations could keep another

bubble from occurring? What should the Fed do now to get the economy back on its

long-run growth path? Let’s start by considering the regulation problem.

The Problem of Regulating the Financial Sector

An engineer who designs a bridge that almost collapses would be questioned thor-

oughly. How did the collapse happen and what can be done to see that it doesn’t hap-

pen again? So it is appropriate to question economists: How did economists not only

let the economic collapse happen, but once the signs of a bubble were clear why didn’t

they warn society that a financial crisis was about to happen?

Economists answer these questions in various ways. Some emphasize that policy

makers were swayed by political interests and wrangling, not by empirical evidence

and economic theory. Politicians, not economists, are to blame for the financial crisis.

These economists point out that a number of economists recognized the problems and

suggested reforms, but policy makers failed to pass new regulations. Moreover, those

regulations that were instituted weren’t executed correctly. The then Fed chair Ben

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688 Macroeconomics ■ Finance, Money, and the Economy

Bernanke expressed this view when he wrote, “The recent financial crisis was more a

failure of economic engineering and economic management than of what I have called

economic science.”

Other economists are not as sure that economic theory can be absolved of

blame. The problem is that in standard economic theory, financial bubbles aren’t

supposed to happen. People are supposed to be rational and rational people don’t

make such major mistakes. In standard economic thinking the prices of assets are

considered the best estimate of those future prices, which is called the efficient

market hypothesis—all financial decisions are made by rational people and are

based on all relevant information that accurately reflects the value of assets today

and in the future. Rational people will recognize that asset prices are rising too

quickly.

The efficient market hypothesis

assumes that all financial decisions are

made by rational people and are based

on all relevant information that accu-

rately reflects the value of assets today

and in the future.

The efficient market hypothesis has an important implication for monetary policy:

Since bubbles can’t happen, monetary policy makers didn’t have to pay attention to

the rising housing prices that occurred in the early 2000s. It wasn’t housing price

inflation; the real value of housing was rising. The efficient market hypothesis said

that asset markets, such as housing, could be left on autopilot. With asset prices set on

automatic, monetary policy could focus on goods market inflation as an indicator of

whether monetary policy was too expansionary. As mentioned above, in the standard

AS/AD model, when there was little inflation and no threat of accelerating inflation,

monetary policy could be expansionary. That was the view that guided conventional

macroeconomic theory. Policy makers didn’t worry about the financial crisis because

conventional economic theory was telling them they didn’t have to worry about it. So

for unconventional economists, conventional economists are to blame. Ben Bernanke

is wrong; it was a failure of economic science.

For unconventional economists,

economic science is to blame for the

financial crisis.

The events of 2008 changed the view that markets are rational for many economists,

including some of the leading advocates of the former conventional model. For

example, another previous Fed chair, Alan Greenspan, stated, “I made a mistake in

presuming that the self-interests of organizations, specifically banks and others, were

such that they were best capable of protecting their own shareholders and their equity

in the firms.” He continued by saying that his conventional worldview was “not

working.” He stated, “That’s precisely the reason I was shocked, because I have been

going for 40 years or more with very considerable evidence that it was working

exceptionally well.”

It was at that point that alternative views about the problems in the economy started

to gain in acceptance. These alternative views held that while people were individually

rational, they could be collectively irrational, following herding behavior. This meant

that asset prices were subject to bubbles, and monetary policy and regulation would

have to be designed to prevent asset price bubbles as well as prevent goods market

inflation. This made conducting monetary policy and designing financial regulation

much more difficult. It is a process that requires institutional knowledge, judgment,

and educated common sense that is on the lookout for bubbles. Policy cannot be based

on fully predetermined rules.

When society can be collectively

irrational, as unconventional economists

believe to be the case, monetary policy

is much more difficult; it requires

institutional knowledge, judgment, and

educated common sense.

One of the commonsense implications of this alternative view was that when mon-

etary policy is too expansionary, and world prices are holding goods market inflation

down because of globalization, excess liquidity from monetary policy could be chan-

neled into asset price bubbles. This was the structural stagnationist’s viewpoint. Many

economists, including behavioral economists, heterodox economists, Post-Keynesian

economists, Austrian economists, and more, had been arguing that bubbles could and

did exist for years. One in particular, Hyman Minsky, a Post-Keynesian economist,

developed a psychological theory that predicted asset price bubbles as almost inevita-

ble in a capitalist economy.

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Chapter 30 ■ Financial Crises, Panics, and Unconventional Monetary Policy 689

So a wide variety of economists of quite different political persuasions accepted

that bubbles were possible. Where they differed was in how bubbles should be dealt

with; these debates are continuing.

Regulation, Bubbles, and the Financial Sector

The assumption that the market on its own can be collectively irrational creates the

need for regulation, or an institutional structure that will prevent that collective irratio-

nality from developing. The question is how that should be done. After the financial

crisis led to a financial meltdown in 1929 and the Great Depression, the United States

instituted strong controls over the financial sector. These regulatory controls were

designed to prevent the financial markets from freezing up again in the future. Govern-

ment set up rules for banks—what they could and could not do; it also set up a system

of deposit insurance—a system under which the federal government promises to

reimburse an individual for any losses due to bank failure—which would help prevent

future bank runs. These rules were strong and were meant to see that a financial crisis

would not happen again.

To implement the deposit insurance program, the government created the Federal

Deposit Insurance Corporation (FDIC)—a government institution that guarantees

bank deposits of up to $250,000. That guarantee discouraged bank runs, but it also cre-

ated a moral hazard problem—a problem that arises when people’s actions do not

reflect the full cost of their actions. Specifically, with deposit insurance, people could

put their money into a bank that offered high interest rates even though the bank made

excessively risky loans. If the bank ran out of money because its loans went bad, the

federal government would cover the loss. Depositors could earn high interest assured

they would not lose their money.

Q-3 What is a lender of last resort

and how does it relate to moral hazard?

To offset the moral hazard problem that deposit insurance would create, govern-

ment: (1) established strict regulations of banks, (2) separated banks from other finan-

cial institutions, and (3) designed systems so that necessary financial transactions that

were central to the operation of the economy stayed within banks. These were included

in a number of financial laws passed in the 1930s, the most important of which was

known as the Glass-Steagall Act—an act of Congress passed in 1933 that established

deposit insurance and implemented a number of banking regulations including pro-

hibiting commercial banks from investing in the securities market. The intent was to

keep commercial banks from speculating in the stock market or in other risky financial

asset markets.

With the institution of these new regulations, the United States had a highly

regulated commercial banking system. The point of the regulations was to make

commercial banking boring—and therefore safe. People called commercial banking

the “3-6-3 business”—borrow at 3 percent, lend at 6 percent, and be on the golf course

by 3 p.m. Banks couldn’t invest in equities and were prohibited from paying interest on

deposits. Both these restrictions reduced the ability of banks to engage in risky

behavior. These regulations were implemented as a result of the Depression, in the

belief that the government could never again let banks go under—they were too

important to fail. And if they were too important to fail, they had to be regulated to

address the moral hazard problems.

It isn’t only deposit insurance that can create a moral hazard. Any type of guaran-

tee, or expectation of bailout, can do the same thing. An example can be seen by con-

sidering the effects of subsidizing loans for homeowners facing foreclosure, or even of

reducing the principal of loans that homeowners owe. Suppose that, in 2005, you had

prudently decided not to buy a house because you believed that houses were already

significantly overpriced. Your foolish friend, on the other hand, bought into the “house

Any type of guarantee, or expectation

of a bailout, can create a moral hazard.

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690 Macroeconomics ■ Finance, Money, and the Economy

prices always rise” myth and decided to buy a big McMansion that he could not really

afford. You were prudent and your friend was foolish, and he’s underwater on his

house and facing foreclosure. Now suppose the government comes along and bails him

out, or lowers the balance on his loan since it doesn’t want him to face foreclosure.

What’s the outcome? He ends up with a nice house and you end up with nothing.

Who’s foolish now?

The belief that the government will bail out people and firms when they make stu-

pid decisions helped create the crisis in the first place, and any bailout now will likely

lead people to expect a bailout in the future. They will then choose to follow riskier

strategies than they otherwise would have, potentially creating even larger problems in

the future. So the bailout rewards precisely the wrong type of behavior, and hence cre-

ates a moral hazard problem for future decisions. To offset those moral hazard prob-

lems, either strict regulation is needed, or the possibilities of bailouts have to be taken

off the table. For individuals, this regulation would mean strict requirements about

down payments and the income level needed to buy a home. For firms it would mean

financial regulations and limitations on what firms too important to fail can and cannot

do. That’s what the Glass-Steagall Act did.

The belief that the government will bail

out people and firms when they make

stupid decisions helped create the crisis

in the first place.

The Law of Diminishing Control

If we had regulations in the 1930s, why didn’t those regulations protect us in 2008?

An important reason is that over time the regulations designed in the 1930s became

less and less effective. The reason can be called the law of diminishing control,

which holds that any regulation will become less effective over time as individuals or

firms being regulated will figure out ways to circumvent those regulations through

innovation, technological change, and political pressure. This means that even if the

initial regulations do what they are supposed to do, over time they will become less

effective. In banking, the financial sector simply moved its risky operations, which

the regulations were meant to prevent, outside the banking sector. So while the

regulations contained risk by keeping the “core” of the banking system within a well-

regulated commercial banking sector, they did not contain risk in the broader financial

sector. It is a bit like the drinking laws for minors in the United States. On most

campuses, the laws don’t stop underage drinking; they just push it into the dorms or

private homes.

Q-4 What causes diminishing control

of regulations?

Trying to regulate banks is a bit like

trying to regulate drinking by minors.

The regulation doesn’t stop it; it just

pushes the problem somewhere else.

New FiNaNcial iNstitutioNs aNd iNstrumeNts An example of finan-

cial innovation that circumvented bank regulation was the creation of NOW (nego-

tiable order of withdrawal) accounts in the 1970s. Under the Glass-Steagall Act

only commercial banks could offer checking accounts, but they couldn’t pay inter-

est on those deposits. Savings banks had the benefit of being able to pay interest on

deposits, but couldn’t offer checking accounts. In the 1970s, savings banks got

around the regulation by issuing what were called NOW accounts. With a NOW

account a customer could direct the savings bank to send funds to a third party.

These withdrawal notices looked almost identical to checks from a commercial

bank. But since the funds were legally considered to be savings accounts, savings

banks avoided regulations prohibiting interest on checking accounts. Money flowed

out of commercial banks and into savings banks. Other financial institutions devel-

oped products such as money market accounts and mutual fund accounts, which

also let depositors write checks on their accounts. These accounts included not just

cash but bonds and even stocks. Regulations no longer solved the problem of pre-

venting the financial sector from paying interest on the new accounts that were the

equivalent of checking accounts.

coL25585_ch30_681-700.indd 690 11/10/18 11:35 AM

Chapter 30 ■ Financial Crises, Panics, and Unconventional Monetary Policy 691

regulatioNs covered Fewer FiNaNcial iNstrumeNts The develop-

ment of new financial instruments described above is just one example. Such changes

occurred in just about every aspect of the law. By the 1980s, it was clear that the Glass-

Steagall Act was no longer preventing activities it was meant to prevent. It simply

moved the practice outside the banking system and into other financial institutions.

By the 1980s it was clear that the Glass-

Steagall Act was no longer preventing

activities it was meant to prevent.

As new financial instruments developed, regulated commercial banks lost business

to unregulated financial institutions. Thus, what had been a protective umbrella over

the financial system that is necessary for a smoothly functioning economy provided

cover for a smaller and smaller segment of the financial industry. The commercial

banking system was still regulated, but the “financial oil” increasingly flowed through

the less regulated parts of the financial infrastructure. This shift was compounded by

the fact that financial markets were becoming global, and the U.S. regulations con-

trolled only U.S. financial institutions. Many U.S financial institutions could legiti-

mately threaten to move to those countries that offered the least regulation. (Think of

it as a child of divorced parents who plays one parent off the other to get the most

lenient rules.) This reduced the ability of the United States to strictly regulate many

financial institutions.

Political Pressure to reduce regulatioNs Politics is another reason

regulation becomes less effective; when regulation successfully eliminates or reduces

the problems, people begin to forget that the regulation was necessary in the first place.

Instead, the groups being regulated view regulations as unnecessary restrictions and

will lobby to dismantle them. With the Great Depression fresh in everyone’s memory,

people in the 1930s favored regulation to avert repeating the Depression. But as

decades passed and societal memories of the Great Depression faded, so did that view.

Regulation and regulators were increasingly viewed by many as undesirable hin-

drances to the free market and all its magic. That was the view that Alan Greenspan

referred to in the earlier quote. The belief that the market could self-regulate meant

that relatively low-paid regulators were faced with the nearly impossible task of bal-

ancing the pressures of innovation that made the regulations obsolete against the need

to get some regulation within an atmosphere that saw regulation as preventing the U.S.

economy from growing.

When regulation successfully eliminates

or reduces the problems, people begin to

forget that the regulation was necessary

in the first place.

Politics also had to deal with an inherent problem of regulation—the too-big-to-

fail problem—the problem that large financial institutions are essential to the work-

ings of an economy, requiring government to step in to prevent their failure. The

too-big-to-fail problem is another example of the moral hazard problem. If individuals

in the financial sector recognize the financial sector’s importance to the economy and

know that the government will be forced to bail them out, they change their behavior,

just like kids change their behavior when they know that their parents will bail them

out. They do stupid things. The problem with kids, and with large banks, is that when

you threaten them that you aren’t going to bail them out, the threat isn’t credible. It

takes resolve that I, and most governments, don’t have. (Note to my children: Mom has

that resolve.) Unless one has that resolve, no threat will be credible, which means that

kids and businesses (with soft parents and soft governments) will continue to do stupid

things; they won’t take the full consequences of their actions into account.

In response to the crisis, in 2010 the United States passed the Dodd-Frank Wall

Street Reform and Consumer Protection Act—a new financial regulatory structure

to limit risk taking and require banks to report their holdings so that regulators could

assess risk-taking behavior. The Dodd-Frank law attempts to minimize the too-big-to-

fail problem. If a company is at risk of default, a process is put in place to liquidate the

corporation, limiting the impact on the economy. The hope is that these regulations

will protect the U.S. economy from future financial meltdowns. The law once again

Q-5 What did government do to

address the too-big-to-fail problem?

coL25585_ch30_681-700.indd 691 11/10/18 11:35 AM

692

REALWORLD APPLICATION

Cryptomania

The law of diminishing control tells us

that new ways of getting around regula-

tions will always be developing, reducing

the value of regulations over time. One

new development in finance involves

what are called cryptocurrencies—which

as I discussed in Chapter 28 are best

thought of as crypto assets, since they

don’t meet the requirement of being a

currency. They are more like a stock—a

bundle of rights that are specified when you buy the as-

set. With stocks you get a percentage of the profits. With

cryptocurrency you get a token, often with no specific

rights, or only a highly ambiguous set of rights to some

activity that is loosely related to the blockchain technol-

ogy that underlies cryptocurrencies. By calling these as-

sets a currency or a token, not a stock, the originators of

cryptocurrencies are attempting to avoid the regulation

that stock offerings must meet. That is now changing.

Governments have increased regulation of initial coin

offerings and are beginning to interpret them more as

stock offerings (which are highly regulated).

Just about all financial advisers advise their clients who

don’t have money to throw away to stay out of the crypto

asset market. But many clients don’t follow that advice,

and billions of dollars are generated by initial coin offer-

ings, with more offerings springing up every day. After all,

from the issuer’s perspective, if you can get someone to

give you $10,000 for a virtual token that costs, perhaps,

10 cents to make, offers little in the way of rights to the

buyer, and is largely unregulated, it’s a

good business deal for the issuer. Want

to buy a Colandercryptotext coin? Only

$200, and $200 will be devoted to think-

ing about how textbooks can incorpo-

rate blockchain technology. (Hint: Not a

good idea.)

Why do people buy crypto assets?

The answer is psychological. When a

person hears stories about how the

price of Bitcoin went from $14 to $20,000, and how

cutting-edge blockchain technology will change the

world he is tempted to get a “piece of the action.” Add to

that the mystical, seductive allure of the name

cryptocurrency—along with a sense of Bitcoin’s association

with the dark web (un-indexed portions of the web, much

of which is dedicated to illegal activities), and high-

pressure salespeople telling you that if you don’t buy

soon you will be left behind, and you can understand

why some investors are hooked, just as they have been

hooked in the past by the South Sea bubble and Tulipmania.

Some people, mainly the issuers, but also some

investors, will make money in crypto assets. Blockchain

technology is revolutionary and in the coming decades

likely will be useful in recording contracts. And even if

the company eventually flops, you can still make money

by buying crypto assets if the hype increases and you

find someone who will pay more for them than you paid.

But when the bubble bursts, people will push for

government regulation.

coL25585_ch30_681-700.indd 692 11/10/18 11:35 AM

limits banks’ ability to invest in securities, consolidates regulatory agencies to improve

their effectiveness, expands oversight to some nonbank financial institutions, and cre-

ates new tools for dealing with financial crises. Unfortunately, few economists believe

that the new law, even before the law of diminishing marginal control has set in, has

resolved the financial regulation problem. Legal and financial scholars on all sides of

the political spectrum have criticized the law as both insufficient to prevent another

financial crisis in some aspects and overly restrictive of financial institutions in others.

With the election of President Trump in 2016, the policy focus turned to deregulation.

The number of banks that were subject to Dodd-Frank requirements was decreased

significantly, and regulations on others were reduced.

Chapter 30 ■ Financial Crises, Panics, and Unconventional Monetary Policy 693

General Principles of Regulation

Economics does not identify ideal regulations, but it does provide some general guide-

lines. The basic guideline is that along with the freedom to undertake activities in the

market comes the responsibility for one’s actions. If firms (or kids) are not, and cannot

be, made responsible for the negative consequences of their actions, there is a role for

regulations to restrict the set of actions firms are permitted to take. Regulation is

necessary if a bailout is in the cards. (As I tell my kids—the golden rule of economics

is: Him who pays the bills makes the rules.)

The basic guideline of regulation is that

along with the freedom to undertake

activities in the market comes

responsibility for one’s actions.

Regulation is necessary if a bailout is in

the cards.

The question policy makers face in trying to design the rules and regulations for

our economy in the future is: Can a government influenced by special interests institute

the right type of regulation? Economists come to different answers on this question,

which is why they have different views of regulation.

Let’s close our discussion of regulation with three general precepts about dealing

with financial crises that most economists would sign on to. They are:

Q-6 What are the three principles of

regulation?

•

Set as few bad precedents as possible. Policies that keep the economy alive

might create long-run problems. Recognize these problems, and try to offset

them as best you can.

•

Deal with moral hazard. If a firm or individual is to be unregulated, it should

be subject to the consequences of its actions. This leads to a corollary: If a firm

or individual is considered too big to fail, it has to be regulated. Notice that this

rule does not say that government should or should not regulate. It just says

that it has to be consistent.

•

Deal with the law of diminishing control. Regulation has to be considered a

process, not a one-time decision. The economy is a dynamic changing entity,

subject to the law of diminishing control, which means that when new business

practices and financial instruments change, rules must change. Expect innovation

and establish a method of changing those regulations to adapt to the changing

situation without weakening the regulations.

Monetary Policy in the Post–Financial Crisis Era

Now let us turn to the question: What monetary policy should the Fed follow after it

has fulfilled its lender of last resort role and avoided a financial crisis? In other words,

what is the Fed’s appropriate monetary policy role in a post–financial crisis era?

Coming out of a financial crisis, the Fed was carrying a large number of loans to

banks and other financial institutions that it made to provide the banks with liquidity.

As the threat of a financial meltdown subsided, that role had ended. The standard prac-

tice would be for the Fed to wind down policies as the lender of last resort, and revert

back to conventional monetary policies. A number of economists called on the Fed to

do precisely that. But with the economy in a deep recession, those policies would have

been highly politically unpopular because they would slow down the recovery.

After the financial crisis subsided, the

standard practice would have been for

the Fed to wind down its lender-of-last-

resort loans. It did not do that because

the economy was in a deep recession.

The argument for unwinding those positions despite the high unemployment was

that this was not your typical recession—it was structural stagnation that reflected

structural problems caused by globalization, and the 5 to 6 percent growth rate needed

until the economy returned to trend was not in the cards. The structural problems that

structural stagnationists see as the cause of the slow growth could not be solved by

monetary policy. To maintain expansionary monetary policy essentially meant

continuing the policies that caused the financial bubble in the first place by expanding

credit in the economy enormously. If the economy is in a structural stagnation,

coL25585_ch30_681-700.indd 693 11/10/18 11:35 AM

694 Macroeconomics ■ Finance, Money, and the Economy

expanding credit beyond the initial triage policy necessary to save the economy from

imploding will only increase the likelihood of a further, possibly even more damaging,

bubble. This is the case even if that policy of monetary restraint will leave the economy

with higher unemployment than otherwise. If the problem facing the U.S. economy

was a structural stagnation, a primary policy focus would have to be on resolving the

structural problems before expansionary monetary policy is called for.

If the problem facing the U.S. economy is

a structural stagnation problem, a primary

policy focus has to be on resolving the

structural problems before expansionary

monetary policy is called for.

In this view, expansionary monetary policy not only would not resolve these struc-

tural problems; it would eliminate the impetus for the private sector to solve them as

well. Expansionary monetary policy in the face of these structural problems would be

analogous to giving painkillers to an addict, when what he needs is detox. According

to structural stagnationists, the appropriate policy would have been for the Fed to

return to conventional monetary policy as soon as possible, even though doing so

would slow the recovery, and possibly even put the economy back into a recession.

The Fed didn’t follow that policy. Instead, it introduced a new unconventional monetary

policy thereby keeping the economy out of a recession, but creating the conditions for

a potential crisis in the future.

Economic theory does not provide definitive answers to what is the correct mone-

tary policy. The data are inevitably ambiguous and subject to various interpretations,

which means that policy has to be based on sensibilities and guesstimates.

The Fed continued running expansionary monetary policy after the United States

emerged from the financial crisis and the recession associated with it. The reasons were:

(1) inflation remained lower than desired; (2) economic growth remained sluggish

(during the upturn, growth was only 2 to 3 percent rather than the 5 to 6 percent they

were hoping for); and (3) there was a fear that ending the expansionary policy would

throw the economy into a recession and possibly even another financial crisis. Only in

2017, when unemployment had fallen to close to 4 percent, did the Federal Reserve

begin switching toward a more conventional monetary policy, and increasing interest

rates, but because of continued slow growth and fears of recession, they were moving

very slowly, and stood ready to reverse policy quickly. What had been seen as

unconventional monetary policy seemed to be becoming the new normal.

Unconventional Monetary Policy

The desire to continue running expansionary policy in the post–financial crisis period

presented a technical problem to the Fed. In its role as a lender of last resort, it had

already done all it could to expand the economy using the tools of conventional mon-

etary policy. The Fed funds rate was essentially zero and the banking system was

awash in reserves. The conventional expansionary monetary policy was not leading to

increases in money and credit; instead it just ended up as excess reserves in the banks

as we saw in the last chapter. To get around this problem, the Fed created a new set of

policies meant to stimulate the economy through unconventional means. These poli-

cies included:

Web Note 30.3

Rear-View Mirror

1. Quantitative easing,

2. Operation twist, and

3. A precommitment policy.

These are the tools of unconventional monetary policy. Let’s consider each of these.

Three unconventional monetary policy

tools are:

1. Quantitative easing,

2. Operation twist, and

3. Precommitment policy.

Quantitative easing As you learned in the last chapter, conventional mone-

tary policy involves open market operations (the Fed buying and selling short-term

coL25585_ch30_681-700.indd 694 11/23/18 8:05 AM

Chapter 30 ■ Financial Crises, Panics, and Unconventional Monetary Policy

695

bonds) to affect the bank reserves and therefore the money supply and the Fed funds

rate). But as we have discussed, in the aftermath of the financial crisis, standard open

market operations did not increase the money supply. The short-term interest rate

approached zero, and even after the Fed flooded the system with reserves, banks did

not make new loans; they simply held more excess reserves. Excess reserves shot up

and the money supply did not increase. If the goal is to stimulate the economy, that

presents a problem.

A way around that problem is quantitative easing—a policy of buying a wide

range of financial assets from banks and other financial institutions in order to stimu-

late the economy. With quantitative easing, the Fed buys a much more diverse set of

assets, such as long-term government bonds and mortgage-backed securities, than it

does with conventional monetary policy. Because quantitative easing doesn’t work

through increasing reserves, or short-term interest rates, it can be expansionary even if

excess reserves are high or if the short-term interest rate is at or near zero. The increase

in the money supply goes directly into the economy, bypassing the conventional

banking sector.

You can see the desired effect of quantitative easing by considering the

yield curve shown in Figure 30-1. As I discussed in the last chapter

conventional monetary policy pushes down on the short end of the yield

curve, with the expectation that in doing so, it will push down the long-run

interest rate as well, thereby shifting the entire curve down. Quantitative

easing pushes the upper end of the yield curve down directly, thereby

holding down the interest rate for investors and stimulating asset markets

and the economy.

coL25585_ch30_681-700.indd 695 11/23/18 8:06 AM

FIGURE 30-1 Quantitative Easing’s Effect

on the Yield Curve

Bond maturity

Interest rate (%)

Quantitative easing might also be called an asset price support system

because it holds the prices of financial assets higher, and long-term interest

rates lower, than they would have been. Thus, the almost trillion dollars of

mortgage-backed securities, which the Fed bought in its quantitative easing

program, held up the prices of those securities, significantly helping

financial institutions and others that held these securities while it lowered

long-term interest rates. It hurt savers, who received low interest rates.

When quantitative easing involves buying long-term nongovernmental

securities such as mortgage-backed securities, or other private assets, it is often

called credit easing or qualitative easing. Qualitative easing and credit easing

differ from quantitative easing because the primary goal of credit and qualitative eas-

ing is to change the quality—or mix—of assets it buys, and not to change the total

amount of assets. You can see the impact of quantitative easing and its variants on the

balance sheet of the Fed in Figure 30-2.

Q-7 How does quantitative easing

differ from conventional monetary

policy?

OperatiOn twist The Fed also added another unconventional tool—operation

twist—selling short-term Treasury bills and buying long-term Treasury bonds without

creating more new money. Like credit easing, operation twist changes the composition

of the Fed’s portfolio; unlike credit easing it does not entail buying private securities.

Its purpose is not to reduce private bank risk, but to lower long-term interest rates.

That is, its purpose is to “twist” the yield curve. The tool was created to address

concerns that because quantitative easing increased the monetary base, it would lead

to inflation. With operation twist, the Fed offset its purchases of long-term bonds by

selling an equal amount of short-term bonds. In principle, selling short-term bonds

would raise short-term interest rates and twist the yield curve, making it flatter. You

Q-8 What effect did the Fed expect

operation twist to have on the yield

curve?

696 Macroeconomics ■ Finance, Money, and the Economy

coL25585_ch30_681-700.indd 696 11/10/18 11:35 AM

FIGURE 30-2 Change in the

Fed’s Assets

In credit easing, the Fed reduces

its traditional security holdings

and replaces them with less

liquid and riskier assets.

Federal Reserve Assets (in trillions of dollars)

Years

2007 2015 2016 20172014 20182012 20132011201020092008

Long-term Treasury purchases

Federal agency debt

mortgage-backed securities

Lending to ﬁnancial institutions

plus liquidity to key markets

Traditional security holdings

can see operation twist by again considering the intended effect on the yield

curve in Figure 30-3.

FIGURE 30-3 Effect of Operation Twist

on the Yield Curve

Long-term

interest rates

Interest rate (%)

down

Short-term

interest rates

3 mo 1 yr 5 yr 30 yr

Bond maturity

Operation twist places downward pressure on the long-term rate and upward

pressure on the short-term rate. In actuality, since banks were holding so many

excess reserves, the effect on the short-term rate was negligible, so only the long

part of the yield curve shifted down, relative to where it otherwise would have

been. But it did so without changing the money supply.

PrecommitmeNt Policy Even with these policies some economists

were concerned that the Fed was not doing enough to expand the economy.

After all, inflation was low and showed no signs of acceleration. Another

unconventional monetary policy that the Fed followed was the precommitment

policy—committing to continue a policy for a prolonged period of time. In 2011

the Fed promised to hold the Fed funds rate close to zero until the end of 2014.

It continued that policy through 2015, but in 2016, it announced that it would

consider slowly raising rates if it felt economic conditions warranted doing so.

Since then and into 2018, the Fed has gradually raised its target for the Federal

funds rate as the economy grew. Precommitment had major significance for

bond and stock investors. It meant that expansionary monetary policy would

continue for two years regardless of the health of the economy or the inflation rate. It

was designed to assure investors that the short-term rate would not rise, which would

have caused losses by investors who held low-interest-rate bonds.

Q-9 What three unconventional

tools did the Fed use to address the

crisis?

wiNdiNg dowN uNcoNveNtioNal moNetary Policy Unconventional

monetary policy was seen as a temporary set of policies that continued for longer than

expected because of the slow growth and low inflation following the recession. In

2017, as the U.S. economy picked up, economists’ thinking turned to how to unwind

Chapter 30 ■ Financial Crises, Panics, and Unconventional Monetary Policy 697

the approximately $4.5 trillion of nontraditional assets that the Fed had accumulated in

its unconventional monetary policy without knocking the economy back into recession

or even further slowing the growth of the economy that many felt was too slow.

Q-10 Why is unwinding

unconventional monetary politically

difficult?

As long as inflation remained below target, there was little pressure on the Fed to

unwind its policies. By 2017, however, most economists felt that with unemployment

low and inflation close to its target rate, it was time for the unwinding to begin. In

October 2017 the Fed did so when it started selling off about $10 billion of its non-

traditional assets a month, a rate that, if followed, would take almost 30 years to unwind.

That pace reflected the Fed’s concern that it should unwind its position in the market

very carefully. The concern was that selling off those assets more quickly would lead to

a sudden fall in asset prices and would be politically unpopular and place the Fed in the

political limelight. So rather than operating in the background of providing a stable

structure for the economy, it would be exposed to greater political criticism.

Conclusion

As I stated earlier in the chapter, economic theory does not provide definitive guidance

on the appropriate monetary policy. The data are too ambiguous, and the interrelation-

ships so complex, that theory cannot provide much help. That’s why there is so much

debate about the appropriate monetary policy. All agree that in the long run, structural

adjustments to our economy are needed, and that unconventional monetary policy

does not offer long-run solutions. Those who oppose unconventional monetary policy

argue that we need to focus on the long run, not the short run.

It isn’t as if any group has a magic

answer to the macro problems that the

United States faces.

The problem with this view is that, as Keynes said back in the 1930s, in the long

run we are all dead. By that he meant not that we can stop worrying about the long run,

but that if the short-run problems are so severe that they will undermine the economy,

then there will be no long run unless we deal with those short-run problems. Deciding

about monetary policy involves making judgments about the severity of short-run

problems relative to long-run problems. Making such judgments involves sensibilities

that go far beyond economics, and thus economists can be expected to disagree, even

when they agree about the theory. What economic understanding can do is to sort out

some of the issues relevant to making those judgments.

Summary

coL25585_ch30_681-700.indd 697 11/10/18 11:35 AM

•

The financial sector provides the credit that all other

sectors need for both day-to-day and long-term needs.

If the financial sector were to collapse, all other

sectors would collapse along with it. (LO30-1)

•

The Fed has the resources and ability to lend to finan-

cial institutions and banks when no one else will,

thereby averting an economic crash. (LO30-1)

•

The elements of a financial crisis are: (1) asset prices

rise to unsustainable levels (a bubble develops),

(2) asset prices fall precipitously (the bubble bursts),

pushing the economy into a financial crisis, and

(3) the economy falls into a severe recession. (LO30-1)

•

Two ingredients of a bubble are herding and

leveraging. Herding creates the run-up in prices.

Leveraging increases people’s ability to herd,

which increases prices further. The Fed can create

a bubble with significant expansionary monetary

policy. (LO30-2)

•

Government regulations that guarantee bailouts for

banks and financial institutions create the moral hazard

698 Macroeconomics ■ Finance, Money, and the Economy

problem, which leads banks and financial institutions to

take risks for which they don’t have to pay. (LO30-3)

•

Regulations have limited impact on bank behavior

because of the law of diminishing control. (LO30-3)

•

Because the failure of large banks would have

disastrous effects on the real economy, they are

considered too big to fail, which leads to the moral

hazard problem. (LO30-3)

•

Three general principles of regulation are: (1) set as

few bad precedents as possible to limit the moral hazard

problem, (2) deal with moral hazard by requiring

banks to face the consequences of their actions, and

(3) change regulations as innovations emerge and

business practices change. (LO30-3)

•

Beginning in 2008, the Fed implemented unconven-

tional policies such as quantitative easing, operation

twist, and precommitment policy. The purpose was to

reduce the amount of risky assets held by banks,

encourage bank lending, and encourage private

borrowing. (LO30-4)

Key Terms

asset price bubble

deposit insurance

Dodd-Frank Wall Street

Reform and Consumer

Protection Act

efficient market

hypothesis

extrapolative

expectations

Federal Deposit

Insurance Corporation

(FDIC)

Glass-Steagall Act

herding

law of diminishing

control

lender of last resort

leverage

liquid

mortgage-backed

securities

operation twist

precommitment policy

quantitative easing

solvent

too-big-to-fail problem

Questions and Exercises

coL25585_ch30_681-700.indd 698 11/23/18 8:07 AM

1. Why is the Fed’s role as lender of last resort an important

function of the Fed? (LO30-1)

2. What role did liquidity play in the financial crisis in

2008? What caused this lack of liquidity? (LO30-1)

3. What is the role of extrapolativ

e expectations in

increasing the price level and creating an asset price

bubble? (LO30-1

)

4. If you invest $200 in a stock, borrowing 90 percent of the

$200 at 10 percent interest, and the stock price rises by

20 percent, what is t

he return on your investment? (LO30-2)

5. Why did the Fed follow far more expansionary policy

than the Taylor rule suggested? (LO30-2)

6. In t

he standard AS/AD model, what role does a financial

bubble play in determining whether an economy exceeds

potential output? Explain your answer.

(LO30-2)

7. What is the efficient market hypothesis and how does it

relate to government regulation? (LO30-3)

8. What is the moral hazar

d problem and how does deposit

insurance lead to it? (LO30-3)

9. What are three reasons why t

he Glass-Steagall Act became

less and less effective? (LO30-3)

10. Why are large f

inancial institutions considered to be too

big to fail? What problem does it create? (LO30-3)

11. Why do some economists believ

e the Fed needs to unwind

monetary policies instituted during the recession? What is

the risk in doing so? (LO30-4

)

12. What distinguishes credit easing from quantitative easing?

What problem was each designed to address? (LO30-4)

13. What distinguishes operation twis

t from credit easing?

(LO30-4)

14. Demonstrate the different effects t

hat quantitative easing

and operation twist were expected to have on the yield

curve. Explain your answ

er. (LO30-4)

15. How was operation twist expected to avoid the criticisms

of quantitative easing? (LO30-4)

16. How would a precommitment policy address pr

oblems in

the economy? What is the risk of such a policy? (LO30-4)

Chapter 30 ■ Financial Crises, Panics, and Unconventional Monetary Policy 699

Questions from Alternative Perspectives

1. Ron Paul, a 2012 and 2016 presidential candidate, be-

lieves that the Federal Reserve should be abolished and

our monetary system should be replaced by a gold stan-

dard. How does the experience of the past decade reflect

on that idea? (Austrian)

2. Hyman Minsky’s theory of fluctuations in output in a

capitalist economy was ignored by mainstream economics

but has proven to be much closer to reality than are theories

suggested by mainstream macroeconomists. What are some

reasons why his theory was ignored? (Post-Keynesian)

3. Post-Keynesian macroeconomist Paul Davidson has argued

that the central characteristic of the Keynesian view of

markets is nonergodicity, which in simple terms implies

the lack of an ability to know or forecast the future. How

does nonergodicity undermine the efficient market hy-

pothesis? (Post-Keynesian)

If Greece makes its bonds legal payment for taxes, it will

be able to sell all the bonds it wants to without worrying

about discounts. What prevents the Greek government

from following this solution? (Post-Keynesian)

5. Many of the regulators and overseers of the government

bailout came from the same firms that brought about the

crisis in the first place. Can we expect reasonable regula-

tion when that is the case? (Radical)

Issues to Ponder

1. If a country goes bankrupt and cannot pay its debts, which

of its responsibilities should take precedence: paying

bondholders or paying the pensions of its employees?

2. If the U.S. economy were t

o go into another financial crisis

and additional monetary stimulus were needed to prevent a

financial collapse, what measures would you sugges

t the

government take?

3. If asset markets aren’t efficient, then it should be possible

for investors to consistently make money by betting that the

price of an asset will r

eturn to its “correct” value. That

doesn’t seem to be the case. Does that suggest that the

efficient market hypothesis is correct?

4. How can economists support a bailout packag

e when

they recognize that the bailout will create a moral hazard

problem?

5. If you had a son whom you had forbidden to drink and dr

ive,

threatening to throw him out of the house if he does drink

and drive, do you throw him out of the house if he does so?

6. In what sense is t

he most recent financial crisis a result of

deregulation?

Answers to Margin Questions

(Continued)

coL25585_ch30_681-700.indd 699 11/23/18 8:08 AM

1. The financial sector facilitates the running of the real

economy. The economy cannot function without the

financial sector. While the automobile industry will affect

the economy, it is not essential to it. (LO30-1)

2. Two central ingredients to a bubble are leveraging and

herding. (LO30-2)

3. The lender of last resort is an institution that promises to

lend to banks and financial institutions when no one else

will. It leads to the mor

al hazard problem because banks

will take greater risks kno

wing the government will cover

their losses. (LO30-3)

4. The effectiveness of regulations falls over time as banks

and financial institutions find ways to circumvent the

regulations and the perceived risk f

acing these institutions

diminishes. (LO30-3)

5. The government implemented new regulations that

limited risk taking by banks and financial institutions.

These ne

w regulations require that they repor

t their assets,

and they established a process of gradually dismantling

financial institutions that face insolvency. (LO30-3)

6. The three principles are: set as few bad precedents as

possible, deal with moral hazard, and deal with the law of

diminishing control. (LO30-3)

700 Macroeconomics ■ Finance, Money, and the Economy

Conventional monetary policy targets the Fed funds rate.

Quantitative easing targets the amount of money in the

economy by buying long-term bonds and

nongovernmental bonds, which adds money directly into

the economy. (LO30-4)

8. Operation twist was implemented to pull long-term

interest rates down and short-term interest rates up, that

is, invert the normal yield curve. (LO30-4)

The three unconventional tools are: quantitative easing,

operation twist, and precommitment policy. (LO30-4)

10. Unwinding unconventional monetary policy is politically

difficult because it will push down asset prices and will

likely slow down the economy. (LO30-4)

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