chap 2 and 3 assignment 1. Why do many economists believe that the market system is the most efficient economic system for allocating resources? 2. W -

chap 2 and 3 assignment
1. Why do many economists believe that the market system is the most efficient economic system for allocating resources?
2. What are the four main categories of resources? Explain each of them.
3. (a) Explain what happens in the simple circular flow diagram? (b) What effect do price controls have on the market system?
4. (a) Explain what can we learn from a country’s production possibilities curve? (b) How can a nation production possibilities curve shift outward? (c) Why the production possibilities cure is bowed-out in shape?
5. Will a nation tend to export or import goods for which it has comparative advantage? Explain.
6. How can we measure the opportunity cost of producing a good? Using a bowed outward production possibilities curve between ice cream and hammers, identify graphically the opportunity cost of obtaining an additional hammer.

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s e v e n t h e d i t i o n

E x p l o r i n g

Macroeconomics

RobeRt L. sexton
Pepperdine University

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s e v e n t h e d i t i o n

E x p l o r i n g

Macroeconomics

RobeRt L. sexton
Pepperdine University

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WCN: 02-200-203

To Teachers of Economics
Everywhere:

Opening Their Students
Minds to the Wonders

of Economics

D E D I C A T I o N

B R I E F C o N T E N T S

1 Introduction
ch 1 The Role and Method ofEconomics 2

ch 2 Economics: Eight Powerful Ideas 31

ch 3 Scarcity, Trade-offs, and Production
Possibilities 70

2 Supply and Demand
ch 4 Demand, Supply, and Market Equilibrium 96

ch 5 Markets in Motion andPriceControls 132

ch 6 Elasticities 155

3 Market Efficiency, Market
Failure, and thePublicSystem

ch 7 Market Efficiency and Welfare 186

ch 8 Market Failure 212

ch 9 Public Finance and Public Choice 238

4 Macroeconomic Foundations
ch 10 Introduction to Macroeconomics:

Unemployment, Inflation, and Economic
Fluctuations 258

ch 11 Measuring Economic Performance 301

ch 12 Economic Growth in the Global Economy 325

ch 13 Financial Markets, Saving, and Investment 347

5 The Macroeconomic Models
ch 14 Aggregate Demand and Aggregate Supply 374

ch 15 The Aggregate Expenditure Model 411

6 Macroeconomic Policy
ch 16 Fiscal Policy 438

ch 17 Money, Banking, and the Federal
ReserveSystem 476

ch 18 Monetary Policy 516

ch 19 Issues in Macroeconomic Theory
andPolicy 546

7 The Global Economy
ch 20 International Trade 578

ch 21 International Finance 611

vii

T A B L E o F C o N T E N T S

1 InTroDUcTIon
C H A P T E R 1
The role and Method ofEconomics 2

1.1 Economics: A Brief introduction 3
EconomicsA Word with Many

DifferentMeanings 3
Economics Is All Around Us 4

1.2 Economic Behavior 5
Self-Interest 5
What Is Rational Behavior? 6

1.3 Economic Theories and Models 9
Economic Theories and Models 9
Abstraction Is Important 9
Developing a Testable Proposition 9
Science and Stories 10
The Ceteris Paribus Assumption 10
Why Are Observation and Prediction Harder in the

Social Sciences? 11
Why Do Economists Predict on aGroupLevel? 11
The Two Branches of Economics: Microeconomics

andMacroeconomics 12

1.4 pitfalls to Avoid in Scientific Thinking 13
Confusing Correlation and Causation 13
The Fallacy of Composition 14

1.5 positive Statements and normativeStatements 15
Positive Statement 15
Normative Statement 16
Positive versus Normative Analysis 16
Disagreement Is Common in Most Disciplines 16
Often Economists Do Agree 17

interactive Summary 19
Key Terms and Concepts 19
Section Quiz Answers 20
Problems 22
Appendix: Working with Graphs 24

C H A P T E R 2
Economics: Eight powerful ideas 31

2.1 iDEA 1: people Face Scarcity and Costly
Trade-offs 32
Introduction 32
Human Wants Exceed Available Resources 32

Scarcity and Resources 33
What Are Goods and Services? 33
What Are Bads? 34
Does Everyone Face Scarcity? 34
Will Scarcity Ever Be Eradicated? 34
Wants versus Needs 34
Scarcity Forces Us to Choose 35
Trade-Offs 35
To Choose Is to Lose 35
Money Costs and Non-money Costs 36
The Opportunity Cost ofGoing to College or Having

aChild 37

2.2 iDEA 2: people Engage in rational Decision Making
and Marginal Thinking 39
Do People Engage in Rational Decision Making? 39
Many Choices We Face Involve Marginal Thinking 39

2.3 iDEA 3: people respond predictably to Changes
inincentives 43
Changes in Incentives Change Individual Behavior 43
Positive and Negative Incentives 43

2.4 iDEA 4: Specialization and Trade Can Make Everyone
Better off 46
Why Do People Specialize? 46
Absolute versus Comparative Advantage 47
We All Specialize 47
The Advantages of Specialization 47
Specialization and Trade Lead to Greater Wealth

andProsperity 48

2.5 iDEA 5: Markets Can improve Economic
Efficiency 50
How Does the Market Work to Allocate

Resources? 51
Market Prices Provide Important Information 51
What Effect Do Price Controls Have on the Market

System? 52

2.6 iDEA 6: Appropriate government policies Can
improve Market outcomes 53
Property Rights and the Legal System 53
Market Failure 53

2.7 iDEA 7: government policies May Help Stabilize
theEconomy 56
Inflation 57
Unemployment 57

2.8 iDEA 8: increasing productivity leads to Economic
growth 59
Defining Economic Growth 59

4.3 Shifts in the Demand Curve 103
A Change in Demand versus a Change

inQuantityDemanded 103
Shifts in Demand (PYNTE) 103
Changes in the Prices of Related Goods and

Services (P) 103
Changes in Income (Y) 105
Changes in the Number ofBuyers (N) 107
Changes in Tastes (T) 107
Changes in Expectations (E) 107
Changes in Demand versus Changes in Quantity

DemandedRevisited 108

4.4 Supply 111
The Law of Supply 111
A Positive Relationship between Price andQuantity

Supplied 111
An Individual Supply Curve 112
The Market Supply Curve 112

4.5 Shifts in the Supply Curve 114
A Change in Quantity Supplied versus

aChangeinSupply 114
Shifts in Supply (SPENT) 114
Change in Supply versus Change in Quantity

SuppliedRevisited 118

4.6 Market Equilibrium price and Quantity 120
The Critical Role of Price 120
Equilibrium Price and Quantity 120
Shortages and Surpluses 120
Dont Confuse Scarcity and Shortages 122

interactive Summary 123
Key Terms and Concepts 124
Section Quiz Answers 124
Problems 126

C H A P T E R 5
Markets in Motion and price
Controls 132

5.1 Changes in Market Equilibrium 133
The Effects of a Change in Demand 133
The Effects of a Change inSupply 134
The Effects of Changes in Both Supply

andDemand 135
The Combinations of Supply and Demand

Shifts 138
Supply, Demand, and the Market Economy 138

5.2 price Controls 144
Price Controls 144
Price Ceilings: Rent Controls 144
Price Floors: The Minimum Wage 145
Price Ceilings: Price Controls onGasoline 147
Unintended Consequences 148

interactive Summary 151
Key Terms and Concepts 151
Section Quiz Answers 151
Problems 153

Economic Growth, Productivity, and the Standard of
Living 60

What Factors Contribute to Increases in
Productivity? 60

interactive Summary 62
Key Terms and Concepts 63
Section Quiz Answers 63
Problems 68

C H A P T E R 3
Scarcity, Trade-offs, and production
possibilities 70

3.1 The Three Economic Questions Every Society Faces 71
The Three Economic Questions 71
What Goods and Services Will Be Produced? 72
How Will the Goods andServices Be Produced? 73
Who Will Get the Goods and Services Produced? 73

3.2 The Circular Flow Model 76
Product Markets 76
Factor Markets 76
The Simple Circular Flow Model 77

3.3 The production possibilities Curve 78
The Production Possibilities Curve 78
Inefficiency and Efficiency 80
The Law of Increasing Opportunity Cost 81

3.4 Economic growth and the production possibilities
Curve 84
Generating Economic Growth 84
Growth Does Not Eliminate Scarcity 85
The Effects of a Technological Change on the

Production Possibilities Curve 86
Summing up the Production Possibilities Curve 86

interactive Summary 88
Key Terms and Concepts 89
Section Quiz Answers 89
Problems 91

2 SUPPly and DEMAnD
C H A P T E R 4
Demand, Supply, and Market
Equilibrium 96

4.1 Markets 97
Defining a Market 97
Buyers and Sellers 97

4.2 Demand 98
The Law of Demand 98
Individual Demand 99
What Is a Market Demand Curve? 99
Ceteris Paribus and the Law of Demand 100

x TABLE oF CoNTENTS

Rent ControlsShort Run versus Long Run 201
Price Floors 202
The Welfare Effects of a Price Floor When the

Government Buys the Surplus 203
Deficiency Payment Program 204

interactive Summary 207
Key Terms and Concepts 207
Section Quiz Answers 208
Problems 210

C H A P T E R 8
Market Failure 212

8.1 Externalities 213
Negative Externalities in Production 213
What Can the Government Doto Correct

for Negative Externalities? 214
Positive Externalities in Consumption 215
What Can the Government Do to Correct forPositive

Externalities? 217
Nongovernmental Solutions to Externalities 217

8.2 public policy and the Environment 219
Why Is a Clean Environment Not Free? 219
The Costs and Benefits of Pollution Control 219
Command and Control Policies: Regulation 220
Pollution Taxes: A Market-Based Policy 221
Transferable Pollution Rights 221

8.3 property rights and the Environment 223
The Coase Theorem 223
Transaction Costs and theCoaseTheorem 224

8.4 public goods 225
Private Goods versus Public Goods 225
Public Goods and the Free-Rider Problem 226
The Government and BenefitCost Analysis 226
Common Resources and the Tragedy ofthe

Commons 227

8.5 Asymmetric information 229
What Is Asymmetric Information? 229
What Is Moral Hazard? 231

interactive Summary 233
Key Terms and Concepts 234
Section Quiz Answers 234
Problems 236

C H A P T E R 9
public Finance and public Choice 238

9.1 public Finance: government Spending
andTaxation 239
Growth in Government 239
State and Local Spending 241
Generating Government Revenue 241
Financing State and Local Government Activities 244
Should We Have a Flat Tax? 244
Taxes: Efficiency and Equity 245

C H A P T E R 6
Elasticities 155

6.1 price Elasticity of Demand 156
Is the Demand Curve Elastic or Inelastic? 156
Types of Demand Curves 157
Calculating the Price Elasticity of Demand: The

Midpoint Method 158
The Determinants of the Price Elasticity

ofDemand 159

6.2 Total revenue and the price Elasticity
ofDemand 163
How Does the Price Elasticity of Demand ImpactTotal

Revenue? 163
Price Elasticity Changes along a Linear Demand

Curve 165

6.3 other Types of Demand Elasticities 169
The Cross-Price Elasticity of Demand 169
Cross-Price Elasticity and Sodas 169
The Income Elasticity of Demand 170

6.4 price Elasticity of Supply 171
What is the Price Elasticity of Supply? 171

interactive Summary 178
Key Terms and Concepts 179
Section Quiz Answers 179
Problems 181

3 MArKET EFFIcIEncy,
MArKET FAIlUrE, AnD
ThEPUBlIcSySTEM

C H A P T E R 7
Market Efficiency and Welfare 186

7.1 Consumer Surplus and producer Surplus 187
Consumer Surplus 187
Marginal Willingness to Pay Falls as More

IsConsumed 187
Price Changes and Changes in Consumer Surplus 188
Producer Surplus 189
Market Efficiency and Producer and Consumer

Surplus 190
Market Efficiency and Market Failure: ACaveat 192

7.2 The Welfare Effects of Taxes, Subsidies, and price
Controls 195
Using Consumer and Producer Surplus to Find the

Welfare Effects of a Tax 195
Elasticity and the Size of the Deadweight Loss 197
The Welfare Effects of Subsidies 198
Price Controls and Welfare Effects 199
Price Ceilings 200
Rent Controls 201

TABLE oF CoNTENTS xi

10.5 inflation 278
Stable Price Level as a Desirable Goal 278
Measuring Inflation 279
The Consumer Price Index and the GDP

Deflator 280
How Is a Price Index Created? 280
Problems with the CPI 281
Producer Price Index 282
GDP Deflator Versus CPI 282
The Price Level over the Years 282
Who Loses with Inflation? 284
Unanticipated Inflation Distorts Price Signals 285
Other Costs of Anticipated

and Unanticipated Inflation 285
Inflation and Interest Rates 285
Do Creditors Always Lose During

Inflation? 286
Protecting Ourselves from Inflation 287

10.6 Economic Fluctuations 289
Short-Term Fluctuations in Economic

Growth 289
The Phases of a Business Cycle 289
How Long Does a Business Cycle Last? 290
Seasonal Fluctuations Affect Economic

Activity 290
Forecasting Cyclical Changes 291

interactive Summary 293
Key Terms and Concepts 295
Section Quiz Answers 295
Problems 298

C H A P T E R 1 1
Measuring Economic performance 301
11.1 national income Accounting: A Standardized

Way to Measure Economic performance 302
What Is Gross Domestic Product? 302
Production, Income, and the Circular Flow

Model 303

11.2 Measuring Total production 305
The Expenditure Approach to Measuring GDP 305
Consumption (C) 305
Investment (I) 306
Government Purchases (G) 307
Exports (X 2 M) 307
The Value-Added or Production Approach 307

11.3 other Measures of Total production
andTotal income 309

11.4 problems in Calculating an Accurate gDp 311
Problems in Calculating an Accurate GDP 311
How Do We Solve This Problem? 311
A Price-Level Index 311
Real GDP 311
Is Real GDP Always Less Than Nominal GDP? 312
Real GDP per Capita 312

9.2 public Choice 249
What Is Public Choice Theory? 249
Scarcity and the Public Sector 250
The Individual ConsumptionPayment Link 250
Majority Rule and the Median Voters 250
Voters and Rational Ignorance 251
Special Interest Groups 252

interactive Summary 254
Key Terms and Concepts 255
Section Quiz Answers 255
Problems 256

4 MAcroEconoMIc
FoUnDATIonS

C H A P T E R 1 0
introduction to Macroeconomics:
Unemployment, inflation, and
Economic Fluctuations 258
10.1 Macroeconomic goals 259

Three Major Macroeconomic Goals 259

10.2 Employment and Unemployment 260
The Consequences of High Unemployment 260
What Is the Unemployment Rate? 261
The Worst Case of U.S. Unemployment 261
Variations in the Unemployment Rate 262
Are Unemployment Statistics Accurate Reflections

ofthe Labor Market? 263
Who Are the Unemployed? 263
Categories of Unemployed Workers 264
How Much Unemployment? 264
How Long Are People Usually

Unemployed? 265
Labor Force Participation Rate 266

10.3 Types of Unemployment 268
Frictional Unemployment 268
Should We Worry about Frictional

Unemployment? 269
Structural Unemployment 269
Some Unemployment Is Unavoidable 270
Cyclical Unemployment 270
The Natural Rate of Unemployment 270

10.4 reasons for Unemployment 274
Why Does Unemployment Exist? 274
Minimum Wages and Unemployment 274
The Impact of Unions on the Unemployment

Rate 274
Efficiency Wage 275
Unemployment Insurance 275
Does New Technology Lead to Greater

Unemployment? 276

xii TABLE oF CoNTENTS

The Value of Securities 350
Reading Stock Tables 350
Financial Intermediaries 351

13.2 Saving, investment, and the Financial System 353
The Macroeconomics of Saving and

Investment 353
The Market for Loanable Funds 355
Analyzing the Market for Loanable Funds 356

13.3 The Financial Crisis of 2008 361
Low Interest Rates (20022004) Led toAggressive

Borrowing 361
Deregulation in the Housing Market andSubprime

Mortgages 361
Who Bought These Risky Subprime

Mortgages? 363
The Fed Raises Interest Rates and the Housing

Bust 363

interactive Summary 366
Key Terms and Concepts 367
Section Quiz Answers 367
Problems 369
Appendix: Calculating Present Value 371

5 ThE MAcroEconoMIc
MoDElS

C H A P T E R 1 4
Aggregate Demand and Aggregate
Supply 374
14.1 The Determinants of Aggregate Demand 375

What Is Aggregate Demand? 375
Consumption (C) 375
Investment (I) 375
Government Purchases (G) 375
Net Exports (X 2 M) 375

14.2 The Aggregate Demand Curve 377
How Is the Quantity of Real GDP Demanded Affected

by the Price Level? 377
Why Is the Aggregate Demand Curve Negatively

Sloped? 378

14.3 Shifts in the Aggregate Demand Curve 380
Shifts versus Movements along the Aggregate Demand

Curve 380
Aggregate Demand Curve Shifters 381

14.4 The Aggregate Supply Curve 384
What Is the Aggregate Supply Curve? 384
Why Is the Short-Run Aggregate Supply Curve

Positively Sloped? 384
Why Is the Long-Run Aggregate Supply Curve

Vertical? 385

Why Is the Measure of per Capita Real GDP
SoImportant? 313

11.5 problems with gDp as a Measure ofEconomic
Welfare 315
Nonmarket Transactions 315
The Underground Economy 315
Measuring the Value of Leisure 315
GDP and Externalities 316
Quality of Goods 317
Other Measures of Economic Well-Being 317

interactive Summary 319
Key Terms and Concepts 320
Section Quiz Answers 320
Problems 322

C H A P T E R 1 2
Economic growth in the global
Economy 325
12.1 Economic growth 326

Defining Economic Growth 326
The Rule of 70 326
Productivity: The Key to a Higher Standard

ofLiving 328

12.2 Determinants of Economic growth 330
Factors that Contribute to Productivity Growth 330
New Growth Theory 332

12.3 public policy and Economic growth 334
The Impact of Economic Growth 334
Saving Rates, Investment, Capital Stock,

andEconomic Growth 334
Infrastructure 335
Research and Development 336
The Protection of Property Rights Impacts Economic

Growth 336
Free Trade and Economic Growth 336
Education 337

12.4 population and Economic growth 340
Population Growth and Economic Growth 340
The Malthusian Prediction 341

interactive Summary 343
Key Terms and Concepts 344
Section Quiz Answers 344
Problems 345

C H A P T E R 1 3
Financial Markets, Saving,
andinvestment 347
13.1 Financial institutions and intermediaries 348

Bonds 349
Stocks 349
Retained Earnings 350

TABLE oF CoNTENTS xiii

6 MAcroEconoMIc PolIcy
C H A P T E R 1 6
Fiscal policy 438
16.1 Fiscal policy 439

Fiscal Policy 439
The Government and Total Spending 439

16.2 Fiscal policy and the AD/AS Model 440
Fiscal Policy and the AD/AS Model 440

16.3 The Multiplier Effect 443
Government Purchases, Taxes, and Aggregate

Demand 443
The Multiplier Effect 444
The Multiplier Effect at Work 444
Changes in the MPC Affect the Multiplier

Process 445
The Multiplier and the Aggregate Demand

Curve 446
Tax Cuts and the Multiplier 446
Taxes and Investment Spending 446
A Reduction in Government Purchases and Tax

Increases 447
Time Lags, Saving, and Imports Reduce the Size of the

Multiplier 447
The 20082009 Recession 448
Were the Predictions of the Stimulus Programs

Accurate? 449

16.4 Supply-Side Effects of Tax Cuts 452
What Is Supply-Side Economics? 452
Impact of Supply-Side Policies 452
The Laffer Curve 452
Research and Development and the Supply Side of the

Economy 453
How Do Supply-Side Policies Affect Long-Run

Aggregate Supply? 453
Critics of Supply-Side Economics 453
The Supply-Side and Demand-Side Effects

of a Tax Cut 454
Fighting Recessions: Tax Cuts or Increasing

Government Purchases 455

16.5 possible obstacles to Effective Fiscal policy 456
The Crowding-Out Effect 456
Crowding Out in the Long Run 457
Fiscal Policy in an Open Economy 457
The Ricardian Equivalence Theorem 458
Time Lags in Fiscal Policy Implementation 458

16.6 Automatic Stabilizers 461
Automatic Stabilizers 461
How Do the Tax System and Transfer

PaymentsStabilize the Economy? 461

16.7 The national Debt 463
How Government Finances the National Debt 463

14.5 Shifts in the Aggregate Supply Curve 387
Shifting Short-Run and Long-Run Supply Curves 387
What Factors Shift the Short-Run Aggregate Supply

Curve Only? 389

14.6 Macroeconomic Equilibrium: The Short run and the
long run 393
Determining Macroeconomic Equilibrium 393
Recessionary and Inflationary Gaps 394
Demand-Pull Inflation 395
Cost-Push Inflation 395
What Helped the United States Recover in the

1980s? 396
A Decrease in Aggregate Demand and Recessions 396
Adjusting to a Recessionary Gap 397
Slow Adjustments to a Recessionary Gap 397
What Causes Wages and Prices to Be Sticky

Downward? 398
Adjusting to an InflationaryGap 398
Price Level and RGDP over Time 399

interactive Summary 401
Key Terms and Concepts 404
Section Quiz Answers 404
Problems 408

C H A P T E R 1 5
The Aggregate Expenditure Model 411
15.1 The Simple Aggregate Expenditure Model 412

Why Do We Assume the Price Level Is Fixed? 412
The Simplest Aggregate Expenditure Model:

Autonomous Consumption Only 412
What Are the Autonomous Factors That Influence

Spending? 413

15.2 Finding Equilibrium in the AggregateExpenditure
Model 415
Revisiting Marginal Propensity to Consume

andSave 416
Marginal Propensity to Save 416
Equilibrium in the Aggregate Expenditure

Model 417
Disequilibrium in the Aggregate Expenditure

Model 418

15.3 Adding investment, government purchases,
and net Exports 421

15.4 Shifts in Aggregate Expenditure and the
Multiplier 424

15.5 From Aggregate Expenditures to Aggregate
Demand 427
Shifts in Aggregate Demand 428
Limitations of the Aggregate Expenditure

Model 429

interactive Summary 431
Key Terms and Concepts 432
Section Quiz Answers 432
Problems 435

xiv TABLE oF CoNTENTS

Fed Pays Interest on Reserves 502
The Discount Rate 502
How the Fed Reduces the Money Supply 503
How the Fed Increases the Mon

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