Preface xi

PART 1 Introduction to economics 2
Chapter 1 Observing and explaining the economy 4
Introduction 5
Foundations of modern economics 6
- From classical to neoclassical 7
The two branches of economics 10
Observations: what economists endeavour to explain 13
- Interpreting the observations 13
- Economic history 14
Economic models 14
- What are economic models? 15
- The use of existing models 18
- The development of new models 18
Using economics for public policy 19
- Positive versus normative economics 19
- Economics as a science versus a partisan policy tool 20
Conclusion: a reader's guide 20
Key points 22
Key terms 22
Questions for review 22
Problems 23
Appendix 24

Chapter 2 Scarcity, choice and economic interaction 28
Introduction 29
Scarcity, choice and interaction for individuals 29
- Consumer decisions 30
- Producer decisions 31
- Trade within a country versus international trade 33
- Multilateral trade and the need for a medium of exchange 33
Scarcity and choice for the economy as a whole 34
- Production possibilities 34
- Increasing opportunity costs 35
- The production possibilities curve 35
Market economies 39
- Three questions 39
- Key elements of a market economy 40
- Prices in action: an example 43
Conclusion 45
Key points 45
Key terms 45
Questions for review 45
Problems 46

Chapter 3 The supply and demand model 48
Introduction 49
Demand 49
- The demand curve 50
- Shifts in demand 51
- Movements along versus shifts of the demand curve 54
Supply 55
- The supply curve 55
- Shifts in supply 56
- Movements along versus shifts of the supply curve 58
Market equilibrium: combining supply and demand 59
- Supply 60
- Demand 60
- Determination of the market price 61
- Finding the equilibrium with a supply and demand diagram 63
- A change in the market 63
Interference with market prices 67
- Price ceilings and price floors 67
- Shortages and related problems resulting from price ceilings 67
- Surpluses and related problems resulting from price floors 69
Conclusion 70
Key points 72
Key terms 72
Questions for review 73
Problems 73

Chapter 4 Elasticity and its uses 74
Introduction 75
The price elasticity of demand 75
- Why the price elasticity of demand is important 75
- Definition of the price elasticity of demand 78
- Terminology for discussing elasticities 80
- Elasticities and sketches of demand curves 81
- Calculating the elasticity with a midpoint formula 81
- Revenue and the price elasticity of demand 81
- Differences in the price elasticity of demand 84
- Income elasticity of demand and cross-price elasticity of demand 85
The price elasticity of supply 88
- Why the price elasticity of supply is important 88
- Definition of the price elasticity of supply 89
Applications of elasticity 91
Conclusion 93
Key points 93
Key terms 93
Questions for review 94
Problems 94

PART 2 Principles of macroeconomics 96

Chapter 5 Macroeconomics: the big picture 98
Introduction 99
Real GDP over time 99
- Economic growth: the relentless uphill climb 100
- Economic reforms: transition to higher growth 101
Unemployment, inflation and interest rates 104
- Employment, productivity and unemployment 104
- Inflation 107
- Interest rates 108
Macroeconomic theory and policy 110
- Economic growth theory and economic fluctuations theory 110
- Aggregate supply and long-term economic growth 110
- Government policy for long-term economic growth 112
- Economic fluctuations theory and policy 113
Conclusion 115
Key points 117
Key terms 117
Questions for review 117
Problems 117
Appendix 120

Chapter 6 Measuring the production, income and spending of nations 122
Introduction 123
Measuring GDP 123
- A precise definition of GDP 123
- The spending approach 125
- The income approach 129
- The production approach 133
Saving and investment 135
- The definition of a country's saving 135
- National saving plus foreign saving equals investment 136
Real GDP and nominal GDP 139
- Adjusting GDP for inflation 139
- The GDP deflator 141
- Alternative inflation measures 142
Shortcomings of the GDP measure 143
- Revisions in GDP 143
- Omissions from GDP 144
- Other measures of wellbeing 145
Conclusion 147
Key points 147
Key terms 147
Questions for review 148
Problems 148

Chapter 7 The spending allocation model 150
Introduction 151
The spending shares 151
- Defining the spending shares 151
- If one share goes up, another must go down 152
The effect of interest rates on spending shares 153
- Consumption 153
- Investment 154
- Net exports 155
- Putting the three shares together 157
Determining the equilibrium interest rate 157
- Adding the non-government shares graphically 158
- The share of GDP available for non-government use 158
- Finding the equilibrium interest rate graphically 158
Shifts in government expenditure and consumption 160
- A shift in government expenditure 160
- A shift in consumption 161
The aggregate saving rate 163
Determination of government's share of GDP 165
- Arguments over the appropriate size of government 165
- Size of government and economic growth 165
Conclusion 167
Key points 167
Key terms 168
Questions for review 168
Problems 168

Chapter 8 Unemployment and employment 170
Introduction 171
Unemployment and other labour market indicators 171
- Cyclical, frictional and structural unemployment 171
- How is unemployment measured? 173
- Comparing three key indicators 176
- Aggregate hours of labour input 177
The nature of unemployment 178
- Reasons people are unemployed 178
- The duration of unemployment 180
- Unemployment for different groups 180
Explaining employment trends 181
- Labour demand and labour supply 181
- Why is the unemployment rate always greater than zero? 182
- Policy implications 185
-The effects of taxes 185
Conclusion 188
Key points 188
Key terms 188
Questions for review 189
Problems 189

Chapter 9 Productivity and economic growth 192
Introduction 193
Labour and capital without technology 194
- Labour alone 194
- Labour and capital alone 199
Labour and capital with technology 202
- What is technology? 203
- The production of technology: the invention factory 205
- Special features of the technology market 207
The growth accounting formula 208
- The formula and its coefficient 208
Technology policy 210
- Policy to encourage investment in human capital 210
- Policy to encourage research and innovation 211
- Technology embodied in new capital 211
- Is government intervention appropriate? 211
Conclusion: where does potential GDP go from here? 213
Key points 214
Key terms 215
Questions for review 215
Problems 215

Chapter 10 Money and inflation 218
Introduction 219
What is money? 219
- Commodity money 219
- Three functions of money 220
- From coins to paper money to deposits 221
- Alternative measures of the money supply 222
The central bank and the banks: creators of money 223
- The Reserve Bank of New Zealand 224
- The balance sheet of a commercial bank 227
- The role of banks in creating money 228
How the central bank controls the money supply: currency plus deposits 231
- The money supply (M ) and bank reserves (BR ) 231
- Currency versus deposits 231
- The money multiplier 232
- Setting the price of cash reserves 234
Money, growth and inflation 235
- The quantity equation of money 235
- Evidence 236
Inflation: effects on unemployment and productivity growth 239
- Effects on unemployment 239
- Effects on productivity growth 240
Conclusion 242
Key points 242
Key terms 243
Questions for review 243
Problems 243

PART 3 Economic fluctuations and macroeconomic policy 246

Chapter 11 The nature and causes of economic fluctuations 248
Introduction 249
Changes in aggregate demand first lead to changes in production 249
- Production and demand at individual firms 250
- Why changes in demand affect production 251
- Could economic fluctuations also be due to changes in potential GDP? 253
Forecasting real GDP 254
- A forecast for next year 254
- Impact of a change in government expenditure 254
The response of consumption to income 255
- The consumption function 255
- What about interest rates and other influences on consumption? 258
Finding real GDP when consumption and income move together 259
- The logic of the two-way link between consumption and income 259
- The 45-degree line 259
- The aggregate expenditure line 260
- Determining real GDP through spending balance 262
- A better forecast of real GDP 264
Spending balance and departures of real GDP from potential GDP 266
- Stepping away from potential GDP 266
Conclusion 268
Key points 268
Key terms 269
Questions for review 269
Problems 270

Chapter 12 The multiplier 272
Introduction 273
How to find the multiplier 273
- A graphical derivation of the multiplier 273
- The multiplier for a general shift in the aggregate expenditure line 274
- An algebraic derivation of the multiplier 275
The size of the multiplier 280
- The multiplier and the slope of the AE line 280
- The multiplier and the marginal propensity to consume 281
- Uncertainty about the size of the multiplier 282
A key international issue: net exports depend on income 282
- How do net exports depend on income? 282
- The AE line when net exports depend on income 284
- Effects on the size of the multiplier 285
- The impact on the trade deficit 287
- Does investment depend on income too? 287
The multiplier for a tax change 288
Conclusion 290
Key points 291
Key terms 291
Questions for review 292
Problems 292
Appendix 294

Chapter 13 The economic fluctuations model 296
Introduction 297
The inflation adjustment line 299
- The inflation adjustment line is initially flat 299
- The inflation adjustment line eventually curves upwards 301
- Changes in expectations shift the inflation adjustment line 301
The aggregate demand curve 303
- Interest rates and real GDP 304
- Interest rates and inflation 306
- Derivation of the aggregate demand curve 308
Combining the IA line and the AD curve 312
Conclusion 314
Key points 314
Key terms 314
Questions for review 315
Problems 315

Chapter 14 Using the economic fluctuations model 318
Introduction 319
Changes in government expenditure 319
- Real GDP and inflation over time 319
- Details on the components of spending 322
- The return to potential GDP after a boom 324
Changes in monetary policy 324
- Reinflation 326
Price shocks 328
- What is a price shock? 328
- The effect of price shocks 328
Combining different scenarios 330
- Monetary policy with a change in government expenditure 330
- Monetary errors and reversals: a boom-bust cycle 331
Conclusion 334
Key points 336
Key terms 336
Questions for review 337
Problems 337

Chapter 15 Fiscal policy 340
Introduction 341
The government budget: taxes, spending, surpluses and public debt 341
- A balanced budget versus a deficit or surplus 341
- The proposed budget versus the actual budget 342
- A look at the government budget 342
- Public debt 344
Countercyclical fiscal policy 347
- Impacts of the instruments of fiscal policy 347
- Countercyclical fiscal policy 350
- The discretion versus rules debate for fiscal policy 352
- The structural versus the cyclical surplus 353
The Fiscal Responsibility Act 1994 354
- Transparency and credibility 355
Conclusion 357
Key points 358
Key terms 358
Questions for review 358
Problems 358

Chapter 16 Monetary policy 360
Introduction 361
Why are central banks independent? 361
- The 'gain then pain' scenario 362
- The political business cycle 363
- Time inconsistency 364
- Possible disadvantages of central bank independence 364
Money demand, the interest rate and money supply 367
- Money demand 367
Gains from credibility 370
- Interpreting policy actions 370
- Expectations and credible disinflation 371
Conclusion 374
Key points 374
Key terms 375
Questions for review 375
Problems 375

Chapter 17 International finance 378
Introduction 379
Balance of trade around the world 379
- The trade balance 379
- Both merchandise trade and services trade are important 380
- The balance of payments 381
Exchange rate determination 385
- Purchasing power parity 386
- The interest rate: a reason for deviations from PPP 390
Fixed exchange rate systems 390
- International gold standard 391
- The Bretton Woods system 391
- Europe: from fixed exchange rates to the euro 392
- The New Zealand dollar exchange rate arrangements 392
Fixed exchange rates and international independence 393
- Loss of international monetary independence 393
- Interventions in the foreign exchange market 394
- Reducing exchange rate risk 394
Conclusion 396
Key points 397
Key terms 397
Questions for review 398
Problems 398

Chapter 18 Macroeconomic debates 400
Introduction 401
Schools of thought in macroeconomics 401
- Developments from the 1930s through to the 1960s 402
- Developments from the 1970s through to the present 405
- Macroeconomic theory at the turn of the century 408
Debates about macroeconomic policy: examples from New Zealand 408
- The mid-1970s fiscal expansion 409
- The 1984 macroeconomic reforms 410
- The 1990 fiscal crisis 411
- Lessons 412
Conclusion 415
Key points 415
Key terms 415
Questions for review 416
Problems 416

PART 4 Economic development and international trade 418

Chapter 19 Economic development 420
Introduction 421
Catching up or not? 421
- Catch-up in the advanced countries 422
- Catch-up in the whole world 423
Economic development 424
- Billions still in poverty 424
- Geographical patterns 425
- Terminology of economic development 425
Spreading and using technology 427
- Empowering entrepreneurs 427
- Remaining problems in developing countries 428
Increasing capital per worker 429
- Population growth 429
- National saving 430
- Foreign investment from the advanced countries 431
Conclusion 434
Key points 434
Key terms 435
Questions for review 435
Problems 435

Chapter 20 The gains from international trade 438
Introduction 439
Recent trends in international trade 439
Adam Smith and free trade 441
- Mutual gains from voluntary exchange of existing goods 441
- Increased competition 441
- The division of labour 442
- Better use of skills and resources in different countries 442
Comparative advantage 442
- A simple example of comparative advantage 443
- Productivity in two countries 444
- Finding the relative price 446
- Measuring the gains from trade 447
- A graphical measure of the gains from trade 448
Reasons for comparative advantage 451
- Labour versus capital resources 452
The transition to free trade 454
- Phase-out of trade restrictions 454
- Trade adjustment assistance 454
- Trade diversification and liberalisation in New Zealand 454
Conclusion 456
Key points 457
Key terms 457
Questions for review 457
Problems 458

Glossary 459
Index 472