Essentials of Economics, Fourth Edition PDF by Anne M. Garnett, Philip Lewis, R. Glenn Hubbard and Anthony Patrick O’brien

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Essentials of Economics, Fourth Edition
By Anne M. Garnett, Philip Lewis, R. Glenn Hubbard and Anthony Patrick O’brien
Essentials of Economics


CONTENTS

About the authors v
Preface vi
The foundation vii
Special features ix
Resources for educators and students xiii
Reviewers xvi
PART 1 INTRODUCTION 1
CHAPTER 1
Economics: foundations and models 2
THREE KEY ECONOMIC IDEAS 4
People are rational 4
People respond to economic incentives 5
Optimal decisions are made at the margin 5
• Solved problem 1.1
Apple makes a decision at the margin 6
SCARCITY, TRADE-OFFS AND THE ECONOMIC
PROBLEM THAT EVERY SOCIETY MUST SOLVE 6
What goods and services will be produced? 6
How will the goods and services be produced? 7
Who will receive the goods and services produced? 7
Centrally planned economies versus market economies 7
The modern ‘mixed’ economy 8
Efficiency and equity 8
ECONOMIC MODELS 9
The role of assumptions in economic models 10
Forming and testing hypotheses in economic models 10
Normative and positive analysis 10
• Don’t let this happen to you
Don’t confuse positive analysis with normative
analysis 11
Economics as a social science 11
• Making the connection 1.1
Good economics doesn’t always mean good politics 12
MICROECONOMICS AND MACROECONOMICS 12
CONCLUSION 13
• An inside look
Rise of the machines: What jobs will survive as
robots move into the workplace? 14
CHAPTER SUMMARY AND PROBLEMS 16
CHAPTER 1 APPENDIX
Using graphs and formulas 20
Graphs of one variable 21
Graphs of two variables 21
Formulas 28
APPENDIX QUESTIONS AND PROBLEMS 30
CHAPTER 2
Choices and trade-offs in the market 32
PRODUCTION POSSIBILITY FRONTIERS
AND REAL-WORLD TRADE-OFFS 34
Graphing the production possibility frontier 34
Increasing marginal opportunity costs 35
• Making the connection 2.1
Trade-offs and emergency aid relief 36
Economic growth 37
COMPARATIVE ADVANTAGE AND TRADE 38
Specialisation and gains from trade 38
Absolute advantage versus comparative
advantage 39
• Don’t let this happen to you
Don’t confuse absolute advantage with comparative
advantage 40
Comparative advantage and the gains from trade 40
• Solved problem 2.1
Comparative advantage and the gains from trade 41
THE MARKET SYSTEM 42
The gains from free markets 42
The market mechanism 43
• Making the connection 2.2
Story of the market system in action: I, pencil 43
The role of the entrepreneur 44
THE LEGAL BASIS OF A SUCCESSFUL
MARKET SYSTEM 45
Protection of private property 45
• Making the connection 2.3
Illegal downloads from cyberspace 46
Enforcement of contracts and property rights 46
CONCLUSION 47
• An inside look
Expansion and production mix at BMW 48
CHAPTER SUMMARY AND PROBLEMS 50
PART 2 HOW THE MARKET WORKS 55
CHAPTER 3
Where prices come from: the interaction of
demand and supply 56
THE DEMAND SIDE OF THE MARKET 58
Demand schedules and demand curves 58
The law of demand 58
Holding everything else constant: the ceteris paribus
condition 59
What explains the law of demand? 59
Variables that shift market demand 60
• Making the connection 3.1
The ageing of the Baby Boom generation 63
A change in demand versus a change in quantity
demanded 63
THE SUPPLY SIDE OF THE MARKET 64
Supply schedules and supply curves 64
The law of supply 64
Variables that shift supply 65
A change in supply versus a change in
quantity supplied 67
MARKET EQUILIBRIUM: PUTTING DEMAND
AND SUPPLY TOGETHER 68
How markets eliminate surpluses and shortages 68
Demand and supply both count 69
Shifts in a curve versus movements along a curve 70
THE EFFECT OF DEMAND AND SUPPLY SHIFTS ON
EQUILIBRIUM 70
• Don’t let this happen to you
Remember: a change in a good’s price does not
cause the demand or supply curve to shift 70
The effect of shifts in supply on equilibrium 71
The effect of shifts in demand on equilibrium 71
The effect of shifts in demand and supply over time 71
• Solved problem 3.1
Demand and supply both count: pharmacists and
accountants 73
• Making the connection 3.2
The rise and rise of fitness trackers 74
• Solved problem 3.2
Demand and supply both count: the Australian
housing market 75
CONCLUSION 77
• An inside look
Global PC shipments decline for 12th straight
quarter but HP bucks fall, Gartner says 78
CHAPTER SUMMARY AND PROBLEMS 80
CHAPTER 3 APPENDIX
Behavioural economics: do people make
their choices rationally? 86
Pitfalls in decision making 86
Ignoring non-monetary opportunity costs 86
• Making the connection 3A.1
Experimental economics: a test of fairness? 87
Business implications of consumers ignoring
non-monetary opportunity costs 88
Failing to ignore sunk costs 88
• Making the connection 3A.2
A blogger who understands the importance
of ignoring sunk costs? 89
Being unrealistic about future behaviour 89
• Solved problem 3A.1
How do you get people to save more of their
income? 90
APPENDIX QUESTIONS AND PROBLEMS 91
CHAPTER 4
Elasticity: the responsiveness of demand
and supply 94
PRICE ELASTICITY OF DEMAND AND ITS
MEASUREMENT 96
Measuring the price elasticity of demand 96
Elastic demand and inelastic demand 97
An example of calculating price elasticities 97
The midpoint formula 98
• Solved problem 4.1
Calculating the price elasticity of demand for
wheat using the midpoint formula 99
When demand curves intersect, the flatter curve
is more elastic 100
Polar cases of perfectly elastic and perfectly
inelastic demand 100
• Don’t let this happen to you
Don’t confuse inelastic with perfectly inelastic 102
THE DETERMINANTS OF THE PRICE ELASTICITY
OF DEMAND 102
Availability of close substitutes 102
Passage of time 103
• Making the connection 4.1
The price elasticity of demand for breakfast
cereal 103
Luxuries versus necessities 103
• Solved problem 4.2
Using price elasticity to analyse the drug
problem 104
Definition of the market 105
Share of the good in the consumer’s budget 105
THE RELATIONSHIP BETWEEN PRICE ELASTICITY
AND TOTAL REVENUE 105
Elasticity and revenue with a linear demand curve 107
• Solved problem 4.3
Price and revenue don’t always move in the
same direction 108
Estimating price elasticity of demand 108
OTHER DEMAND ELASTICITIES 108
Cross-price elasticity of demand 108
Income elasticity of demand 109
• Making the connection 4.2
Using elasticity to analyse the disappearing
family farm 110
THE PRICE ELASTICITY OF SUPPLY AND ITS
MEASUREMENT 111
Measuring the price elasticity of supply 111
Determinants of the price elasticity of supply 111
• Making the connection 4.3
Why are oil prices so unstable? 113
Polar cases of perfectly elastic and perfectly
inelastic supply 114
Using price elasticity of supply to predict changes
in price 114
CONCLUSION 116
• An inside look
Liquor retailing in Australia 118
CHAPTER SUMMARY AND PROBLEMS 120
CHAPTER 5
Economic efficiency, government price
setting and taxes 126
CONSUMER SURPLUS AND PRODUCER
SURPLUS 128
Consumer surplus 128
Producer surplus 129
• Making the connection 5.1
The consumer surplus from broadband
Internet service 130
What consumer surplus and producer surplus
measure 131
THE EFFICIENCY OF COMPETITIVE MARKETS 132
Marginal benefit equals marginal cost in competitive
equilibrium 132
Economic surplus 133
Deadweight loss 133
Economic surplus and economic efficiency 134
GOVERNMENT INTERVENTION IN THE MARKET:
PRICE FLOORS AND PRICE CEILINGS 134
Price floors: the example of agricultural markets 134
Price ceilings: the example of rent controls 136
• Making the connection 5.2
Price floors in labour markets: the minimum wage 137
Black markets and peer-to-peer sites 138
• Don’t let this happen to you
Don’t confuse scarcity with a shortage 138
• Solved problem 5.1
What is the economic effect of a black market for
apartments? 139
The results of government intervention: winners,
losers and inefficiency 140
Positive and normative analysis of price ceilings
and price floors 140
THE ECONOMIC IMPACT OF TAXES 141
The effect of taxes on economic efficiency 141
Tax incidence: who actually pays a tax? 142
• Solved problem 5.2
When do consumers pay all of a sales tax
increase? 143
CONCLUSION 145
• An inside look
Australian smokers to pay more than $45 for
a packet of cigarettes from 2020 146
CHAPTER SUMMARY AND PROBLEMS 148
PART 3 FIRMS AND MARKET STRUCTURES 153
CHAPTER 6
Technology, production and costs 154
TECHNOLOGY: AN ECONOMIC DEFINITION 156
THE SHORT RUN AND THE LONG RUN
IN ECONOMICS 156
The difference between fixed costs and
variable costs 156
• Making the connection 6.1
Improving inventory control at Bunnings 157
Implicit costs versus explicit costs 157
• Making the connection 6.2
Fixed costs in the publishing industry 158
The production function 158
A first look at the relationship between production
and cost 159
THE MARGINAL PRODUCT OF LABOUR AND THE
AVERAGE PRODUCT OF LABOUR 160
The law of diminishing returns 161
• Making the connection 6.3
Adam Smith’s famous account of the division of
labour in a pin factory 161
The relationship between marginal product
and average product 162
Graphing production 162
THE RELATIONSHIP BETWEEN SHORT-RUN
PRODUCTION AND SHORT-RUN COST 164
Marginal cost 164
The relationship between marginal cost
and average total cost 164
• Solved problem 6.1
The relationship between marginal cost
and average total cost 165
GRAPHING COST CURVES 166
COSTS IN THE LONG RUN 168
Economies of scale 168
Long-run average cost curves for bookshops 168
• Solved problem 6.2
Using long-run average cost curves to
understand business strategy 170
• Making the connection 6.4
The colossal River Rouge: diseconomies of scale
at the Ford Motor company 171
• Don’t let this happen to you
Don’t confuse diminishing returns with
diseconomies of scale 171
CONCLUSION 173
• An inside look
Tesla: The Gigafactory is the key 174
CHAPTER SUMMARY AND PROBLEMS 176
CHAPTER 7
Firms in perfectly competitive markets 182
PERFECTLY COMPETITIVE MARKETS 184
A perfectly competitive firm cannot affect the
market price 185
The demand curve for the output of a perfectly
competitive firm 185
• Don’t let this happen to you
Don’t confuse the demand curve for Farmer Jones’
oats with the market demand curve for oats 187
HOW A FIRM MAXIMISES PROFIT IN A PERFECTLY
COMPETITIVE MARKET 187
Revenue for a firm in a perfectly competitive
market 187
Determining the profit-maximising level of output 188
ILLUSTRATING PROFIT OR LOSS ON THE COST
CURVE GRAPH 190
Showing profit on the graph 191
• Solved problem 7.1
Determining profit-maximising price and
quantity 191
• Don’t let this happen to you
Remember that firms maximise total profit,
not profit per unit 193
Illustrating when a firm is breaking even or
operating at a loss 194
DECIDING WHETHER TO PRODUCE OR TO SHUT
DOWN IN THE SHORT RUN 194
• Making the connection 7.1
Losing money in the solar panel industry 195
• Solved problem 7.2
When to shut down an oil well 196
The supply curve of the firm in the short run 197
The market supply curve in a perfectly competitive
industry 198
‘IF EVERYONE CAN DO IT, YOU CAN’T MAKE
MONEY AT IT’—THE ENTRY AND EXIT OF FIRMS
IN THE LONG RUN 198
Economic profit and the entry or exit decision 199
Long-run equilibrium in a perfectly competitive
market 202
The long-run supply curve in a perfectly competitive
market 202
Increasing-cost and decreasing-cost industries 203
• Making the connection 7.2
In the App Store, easy entry makes the long run
pretty short 204
PERFECT COMPETITION AND EFFICIENCY 204
Productive efficiency 205
Allocative efficiency 205
Dynamic efficiency 205
• Solved problem 7.3
How productive efficiency and dynamic efficiency
benefit consumers 205
CONCLUSION 207
• An inside look
Why the sharing economy could have a hard
landing in Australia 208
CHAPTER SUMMARY AND PROBLEMS 210
CHAPTER 8
Monopoly markets 216
IS ANY FIRM EVER REALLY A MONOPOLY? 218
WHERE DO MONOPOLIES COME FROM? 218
• Making the connection 8.1
Does Hasbro have a monopoly on Monopoly? 219
Entry blocked by government action 219
Control of a key resource 220
Network externalities 220
• Making the connection 8.2
Are diamond (profits) forever? The De Beers diamond
monopoly 221
Natural monopoly 222
HOW DOES A MONOPOLY CHOOSE PRICE
AND OUTPUT? 223
Marginal revenue 223
Profit maximisation for a monopolist 224
• Solved problem 8.1
Finding profit-maximising price and output for
a monopolist 226
• Don’t let this happen to you
Don’t assume that charging a higher price is
always more profitable for a monopolist 227
DOES MONOPOLY REDUCE ECONOMIC
EFFICIENCY? 227
Comparing monopoly and perfect competition 227
Measuring the efficiency losses from monopoly 228
How large are the efficiency losses due to
monopoly? 229
Market power and technological change 229
GOVERNMENT POLICY TOWARDS MONOPOLIES 230
Trade practices laws and enforcement 230
Mergers: the trade-off between market power and
efficiency 232
• Making the connection 8.3
Anti-competitive behaviour in the airline
cargo industry 234
Regulating natural monopolies 234
• Solved problem 8.2
Water restrictions and water supply companies 236
CONCLUSION 237
• An inside look
Footy fans stuck with Foxtel until 2022 238
CHAPTER SUMMARY AND PROBLEMS 240
CHAPTER 8 APPENDIX
Price discrimination 244
The requirements for successful price discrimination 244
• Solved problem 8A.1
How Dell Technologies uses price discrimination to
increase profits 246
Airlines: the kings of price discrimination 247
Perfect price discrimination 247
Price discrimination across time 248
• Making the connection 8A.1
The Internet leaves you open to price discrimination 249
APPENDIX QUESTIONS AND PROBLEMS 250
CHAPTER 9
Monopolistic competition and oligopoly 252
DEMAND AND MARGINAL REVENUE FOR A FIRM
IN A MONOPOLISTICALLY COMPETITIVE MARKET 254
The demand curve for a monopolistically
competitive firm 254
Marginal revenue for a firm with a downward-sloping
demand curve 255
HOW A MONOPOLISTICALLY COMPETITIVE FIRM
MAXIMISES PROFIT IN THE SHORT RUN 257
• Solved problem 9.1
How not to maximise profit 259
WHAT HAPPENS TO PROFIT IN THE LONG RUN? 259
How does entry of new firms affect the profits of
existing firms? 259
• Don’t let this happen to you
Don’t confuse zero economic profit with zero
accounting profit 261
• Making the connection 9.1
The rise and decline and rise of Starbucks 262
Is zero economic profit inevitable in the long run? 262
• Solved problem 9.2
Buffalo Wild Wings increase costs to increase
demand 263
COMPARING PERFECT COMPETITION AND
MONOPOLISTIC COMPETITION 264
Excess capacity under monopolistic competition 265
Is monopolistic competition inefficient? 265
How consumers benefit from monopolistic
competition 266
OLIGOPOLY AND BARRIERS TO ENTRY 266
Barriers to entry 266
GAME THEORY AND OLIGOPOLY 266
A duopoly game: price competition between two firms 267
Firm behaviour and the prisoners’ dilemma 268
• Don’t let this happen to you
Don’t misunderstand why each manager ends up
charging a price of $450 268
Can firms escape the prisoners’ dilemma? 269
• Making the connection 9.2
Is there a dominant strategy for bidding on eBay? 270
• Solved problem 9.3
Is advertising a prisoners’ dilemma for Coca-Cola
and Pepsi? 270
Cartels: the case of OPEC 271
• Making the connection 9.3
Is Virgin Australia’s business strategy more
important than the structure of the airline industry? 273
CONCLUSION 274
• An inside look
Booming coffee market moves into consolidation
phase 276
CHAPTER SUMMARY AND PROBLEMS 278
PART 4 MARKETS FOR FACTORS
OF PRODUCTION 287
CHAPTER 10
The markets for labour and other factors
of production 288
THE DEMAND FOR LABOUR 290
The marginal revenue product of labour 290
• Solved problem 10.1
Hiring decisions by a firm that is a price maker 292
The market demand curve for labour and the factors
that shift it 293
THE SUPPLY OF LABOUR 294
The market supply curve of labour and the factors
that shift it 295
EQUILIBRIUM IN THE LABOUR MARKET 296
The effect on equilibrium wages of a shift in labour
demand 296
• Making the connection 10.1
Will your future income depend on which courses
you take at university? 297
The effect on equilibrium wages of a shift in labour
supply 298
• Making the connection 10.2
Should you fear the effect of robots on the
labour market? 298
EXPLAINING DIFFERENCES IN WAGES 300
• Don’t let this happen to you
Remember that prices and wages are determined
at the margin 302
• Making the connection 10.3
Technology and the earnings of ‘superstars’ 302
Compensating differentials 303
Discrimination 303
Trade unions 306
• Solved problem 10.2
Is ‘comparable worth’ legislation the answer to
closing the gap between men’s and women’s pay? 307
PERSONNEL ECONOMICS 308
Should workers’ pay depend on how much they work
or on how much they produce? 308
Other considerations in setting compensation schemes 309
THE MARKETS FOR CAPITAL AND NATURAL
RESOURCES 310
The market for capital 310
• Solved problem 10.3
How to receive your payments 312
The market for natural resources 314
Monopsony 314
The marginal productivity theory of income
distribution 314
CONCLUSION 315
• An inside look
Huge Indian Premier League pay day for
England bad boy Ben Stokes 316
CHAPTER SUMMARY AND PROBLEMS 318
PART 5 THE ROLE OF GOVERNMENT 325
CHAPTER 11
Government intervention in the market 326
WHAT’S GOOD ABOUT MARKETS AND WHY
DOES THE GOVERNMENT INTERVENE? 328
The economic bases for government intervention 328
MARKET FAILURE AND GOVERNMENT FAILURE 331
• Don’t let this happen to you
Just because something is wrong, it doesn’t mean
the government has to put it right 333
Deregulation and privatisation 333
EXTERNALITIES AND EFFICIENCY 334
The effect of externalities 334
How externalities in production reduce economic
efficiency 335
How externalities in consumption reduce economic
efficiency 336
Externalities and market failure 338
What causes externalities? 338
The economically efficient level of pollution reduction 339
• Making the connection 11.1
The reduction in lead in Melbourne’s air 340
• Don’t let this happen to you
Remember that it’s the net benefit that counts 342
Do property rights matter? 342
The problem of transactions costs 342
The Coase theorem 342
• Making the connection 11.2
The fable of the bees 343
GOVERNMENT POLICIES TO DEAL
WITH EXTERNALITIES 343
Policies for externalities in production 344
Policies for externalities in consumption 345
Command and control and market-based approaches 346
• Making the connection 11.3
Should the government tax soft drinks? 347
• Solved problem 11.1
Using a tax to deal with a negative externality 348
Licences to pollute? 349
• Making the connection 11.4
Can a price on carbon reduce global warming? 349
FOUR CATEGORIES OF GOODS 351
The optimal quantity of a public good 352
Common resources 352
POLICY FOR BUSINESS AND INDIVIDUAL
BEHAVIOUR THAT CAN INCREASE ECONOMIC
EFFICIENCY 354
The rule of law 354
Patents, trademarks and copyright protection 354
• Making the connection 11.5
Who owns the Wizard of Oz? 355
Asymmetric information 356
CONCLUSION 359
• An inside look
Too big to fail: China pledges to set up landmark
emissions trading scheme 360
CHAPTER SUMMARY AND PROBLEMS 362
CHAPTER 12
Social policy and inequality 370
THE TAX SYSTEM 372
An overview of the Australian tax system 373
Progressive and regressive taxes 374
• Making the connection 12.1
Which groups pay the most in taxes? 375
Marginal and average income tax rates 375
Evaluating taxes 376
TAX INCIDENCE REVISITED: THE EFFECT
OF PRICE ELASTICITY 378
• Don’t let this happen to you
Remember not to confuse who pays the tax with
who bears the burden of the tax 379
• Making the connection 12.2
Do companies really bear the burden of the federal
company income tax? 380
• Solved problem 12.1
The effect of price elasticity on the excess burden
of a tax 380
INCOME DISTRIBUTION AND POVERTY 381
Measuring the distribution of income and poverty 381
The poverty rate in Australia 382
Explaining income inequality 383
Showing the income distribution with a Lorenz
curve 384
Problems in measuring poverty and the distribution
of income 385
• Solved problem 12.2
Are many individuals stuck in poverty? 386
• Making the connection 12.3
Is income all that matters? 388
CONCLUSION 389
• An inside look
3.6 million households pay no net tax after churn 390
CHAPTER SUMMARY AND PROBLEMS 392
PART 6 MACROECONOMIC
FOUNDATIONS 397
CHAPTER 13
GDP: measuring total production, income
and economic growth 398
GROSS DOMESTIC PRODUCT MEASURES TOTAL
PRODUCTION 401
Measuring total production: gross domestic
product 401
Measuring GDP using the value-added method 402
Other measures of total production and total
income 402
• Solved problem 13.1
Calculating GDP 403
METHODS OF MEASURING GROSS DOMESTIC
PRODUCT 403
Production, expenditure and income and the
circular-flow diagram 404
Components of GDP 406
• Don’t let this happen to you
Remember what economists mean by investment 406
An equation for GDP and some actual values 407
DOES GDP MEASURE WHAT WE WANT IT
TO MEASURE? 408
Shortcomings in GDP as a measure of total
production 408
• Making the connection 13.1
Why do many developing countries have such
large underground economies? 409
Shortcomings of GDP as a measure of wellbeing 409
• Making the connection 13.2
How else can we measure economic wellbeing? 410
REAL GDP VERSUS NOMINAL GDP 411
Calculating real GDP 411
CALCULATING THE ECONOMIC GROWTH RATE 412
The GDP deflator 412
• Making the connection 13.3
How did the standard of living in Nigeria almost
double overnight? 413
LONG-RUN ECONOMIC GROWTH IS THE KEY
TO RISING LIVING STANDARDS 414
• Making the connection 13.4
The connection between economic prosperity
and health 416
Calculating growth rates and the rule of 70 417
What determines the rate of long-run economic
growth? 417
• Solved problem 13.2
Where does long-run growth come from? 419
Potential GDP 419
WHAT DETERMINES HOW FAST ECONOMIES
GROW? 420
The per-worker production function 421
Which is more important for economic growth:
more capital or technological change? 422
Technological change: the key to sustaining
economic growth 422
New growth theory 422
Is economic growth good or bad? 424
CONCLUSION 425
• An inside look
The four factors that drag Australia down 426
CHAPTER SUMMARY AND PROBLEMS 428
CHAPTER 14
Unemployment and inflation 436
MEASURING THE UNEMPLOYMENT RATE AND
THE LABOUR FORCE PARTICIPATION RATE 438
The labour force survey 438
Problems with measuring the unemployment rate 440
• Solved problem 14.1
What would happen if the ABS labour force survey
included the military? 440
Trends in labour force participation 441
How long are people usually unemployed? 442
Job creation and job destruction 442
• Making the connection 14.1
What explains the increase in welfare recipients? 443
• Solved problem 14.2
Correctly interpreting labour force data 444
THE COSTS OF UNEMPLOYMENT 445
Costs to the economy 446
Costs to the individual 446
The distribution of unemployment 446
TYPES OF UNEMPLOYMENT 447
Cyclical unemployment 448
Frictional unemployment and job search 449
Structural unemployment 449
Full employment 450
• Don’t let this happen to you
Don’t confuse full employment with a zero
unemployment rate 450
EXPLAINING FRICTIONAL AND STRUCTURAL
UNEMPLOYMENT 450
Government policies and the unemployment rate 450
Social security and other payments to the
unemployed 451
Labour market regulation and deregulation 451
Minimum wages 453
Trade unions 453
Efficiency wages 453
• Making the connection 14.2
Why did Henry Ford pay his workers twice
as much as other car manufacturers? 454
MEASURING INFLATION 454
The consumer price index 455
Is the CPI accurate? 457
• Don’t let this happen to you
Don’t confuse the price level with the inflation
rate 458
The producer price index 458
USING PRICE INDEXES TO ADJUST FOR THE
EFFECTS OF INFLATION 458
• Solved problem 14.3
What has been happening with real wages in
Australia? 459
DOES INFLATION IMPOSE COSTS ON THE
ECONOMY? 460
Inflation affects the distribution of income 460
The problem with anticipated inflation 460
The problem with unanticipated inflation 461
Hyperinflation 461
Deflation 462
• Making the connection 14.3
What’s so bad about falling prices? 462
WHAT CAUSES INFLATION? 463
CONCLUSION 465
• An inside look
All eyes on inflation next week, but not everything
is as it seems . . . 466
CHAPTER SUMMARY AND PROBLEMS 468
CHAPTER 15
Aggregate demand and aggregate supply
analysis 476
THE BUSINESS CYCLE 478
Some basic business cycle definitions 478
What happens during the business cycle 479
• Don’t let this happen to you
Don’t confuse short-run fluctuations with long-run
trends 483
AGGREGATE DEMAND 485
Why is the aggregate demand curve downward
sloping? 486
Shifts of the aggregate demand curve versus
movements along it 487
The variables that shift the aggregate demand
curve 487
• Don’t let this happen to you
Be clear why the aggregate demand curve is
downward sloping 487
• Making the connection 15.1
Should Germany reduce its reliance on exports? 490
• Solved problem 15.1
Movements along the aggregate demand curve
versus shifts of the aggregate demand curve 491
AGGREGATE SUPPLY 492
The long-run aggregate supply curve 492
Shifts in the long-run aggregate supply curve 492
The short-run aggregate supply curve 493
Shifts of the short-run aggregate supply curve
versus movements along it 494
Variables that shift the short-run aggregate supply
curve 494
Variables that shift the short-run and long-run
aggregate supply curves 495
MACROECONOMIC EQUILIBRIUM IN THE LONG
RUN AND THE SHORT RUN 496
Recessions, expansions and supply shocks 497
A DYNAMIC AGGREGATE DEMAND AND
AGGREGATE SUPPLY MODEL 500
What is the usual cause of inflation? 501
• Making the connection 15.2
Does technological change create
unemployment? 503
• Solved problem 15.2
Showing the oil shock of 1974 on a dynamic
aggregate demand and aggregate supply graph 504
CONCLUSION 505
• An inside look
Housing boom lifts Harvey Norman’s profit 506
CHAPTER SUMMARY AND PROBLEMS 508
CHAPTER 15 APPENDIX
The aggregate expenditure model 514
Showing a recession on the 45˚ line diagram 518
APPENDIX SUMMARY AND PROBLEMS 520
PART 7 MONETARY AND FISCAL POLICY 523
CHAPTER 16
Money, banks and the Reserve Bank of
Australia 524
WHAT IS MONEY AND WHY DO WE NEED IT? 526
Barter and the invention of money 526
The functions of money 527
• Making the connection 16.1
Money in a World War II prisoner-of-war camp 527
What can serve as money? 528
• Making the connection 16.2
Coca-Cola dries up as the Zimbabwe currency
no longer serves as money 529
HOW DO WE MEASURE MONEY TODAY? 530
M1: the narrowest definition of the money supply 530
Broader definitions of money 530
• Don’t let this happen to you
Don’t confuse money with income or wealth 532
• Making the connection 16.3
Are bitcoins money? 532
HOW DO FINANCIAL INSTITUTIONS CREATE
MONEY? 534
Bank balance sheets 534
Using T-accounts to show how a bank can create money 535
The simple deposit multiplier 537
• Solved problem 16.1
Showing how banks create money 537
The simple deposit multiplier versus the real-world
deposit multiplier 539
AN OVERVIEW OF THE FINANCIAL SYSTEM 540
The role of financial markets and financial
intermediaries 540
The Reserve Bank of Australia 541
How the RBA manages financial liquidity and
interest rates 542
Exchange rate management 544
CONCLUSION 545
• An inside look
Innovation in electronic payments to accelerate
demise of cheques 546
CHAPTER SUMMARY AND PROBLEMS 548
CHAPTER 17
Monetary policy 554
WHAT IS MONETARY POLICY? 556
The goals of monetary policy 556
THE DEMAND FOR AND SUPPLY OF MONEY 558
The demand for money 558
Shifts in the money demand curve 558
How the RBA manages the supply of cash 559
Equilibrium in the money market 561
The market for loanable funds 562
• Making the connection 17.1
Ebenezer Scrooge: accidental promoter of
economic growth? 564
• Solved problem 17.1
Are future budget deficits a threat to the
economy? 566
A tale of two interest rates 567
MONETARY POLICY AND ECONOMIC ACTIVITY 567
How interest rates affect aggregate demand 567
• Making the connection 17.2
Why did the Global Financial Crisis occur? 569
The effects of monetary policy on real GDP and the
price level 569
Can the RBA eliminate contractions and
recessions? 571
Using monetary policy to fight inflation 571
• Solved problem 17.2
The effects of monetary policy 573
Is monetary policy always effective and fair? 574
• Don’t let this happen to you
Remember that with monetary policy, it’s the
interest rate—not the money—that counts 575
• Making the connection 17.3
How does the RBA measure inflation? 576
IS THE INDEPENDENCE OF THE RESERVE BANK OF
AUSTRALIA A GOOD IDEA? 577
The case for RBA independence 577
The case against RBA independence 578
CONCLUSION 579
• An inside look
RBA independence on interest rates: a tick for
a resilient economy 580
CHAPTER SUMMARY AND PROBLEMS 582
CHAPTER 18
Fiscal policy 588
WHAT IS FISCAL POLICY? 590
What fiscal policy is and what it isn’t 590
Automatic stabilisers versus discretionary fiscal
policy 590
An overview of government spending and taxes 590
USING FISCAL POLICY TO INFLUENCE
AGGREGATE DEMAND 593
Expansionary fiscal policy 593
Contractionary fiscal policy 594
• Don’t let this happen to you
Don’t confuse fiscal policy and monetary policy 595
THE MULTIPLIER EFFECT AND GOVERNMENT
PURCHASES AND TAX MULTIPLIERS 595
The government purchases multiplier 595
A simple formula for the multiplier 598
Summarising the multiplier effect 599
The tax multiplier 599
The effect of changes in tax rates 599
Taking into account the effects of aggregate supply 600
The multipliers work in both directions 600
• Making the connection 18.1
The multiplier in reverse: the Great Depression of
the 1930s 601
• Solved problem 18.1
Fiscal policy multipliers 602
THE LIMITS TO USING FISCAL POLICY TO STABILISE
THE ECONOMY 602
Does government spending reduce private spending? 603
Crowding out in the short run 603
Crowding out in the long run 604
• Making the connection 18.2
Why was the United States’ recession of 2007–2009
so severe? 604
DEFICITS, SURPLUSES AND FEDERAL
GOVERNMENT DEBT 606
How the federal budget can serve as an automatic
stabiliser 608
Should the federal budget always be balanced? 609
• Solved problem 18.2
The effect of economic fluctuations on the budget
deficit 609
Is government debt a problem? 609
• Making the connection 18.3
Government bankruptcy in Europe 610
THE EFFECTS OF FISCAL POLICY IN THE LONG RUN 612
The long-run effects of tax policy 612
Tax simplification 613
The economic effect of tax reform 613
How large are supply-side effects from tax cuts? 614
CONCLUSION 615
• An inside look
Japan cabinet approves $175b fiscal boost 616
CHAPTER SUMMARY AND PROBLEMS 618
CHAPTER 18 APPENDIX 1
Is there a short-run trade-off between
unemployment and inflation? 624
The Phillips curve 624
Explaining the Phillips curve with aggregate
demand and aggregate supply curves 625
Is the Phillips curve a policy menu? 626
Is the short-run Phillips curve stable? 626
The long-run Phillips curve 626
The role of expectations of future inflation 627
Do workers understand inflation? 628
APPENDIX 1 QUESTIONS AND PROBLEMS 629
CHAPTER 18 APPENDIX 2
A closer look at the multiplier 630
An expression for equilibrium real GDP 630
A formula for the government purchases multiplier 631
A formula for the tax multiplier 631
The ‘balanced budget’ multiplier 632
The effects of changes in tax rates on the multiplier 632
The multiplier in an open economy 633
APPENDIX 2 PROBLEMS 634
PART 8 THE INTERNATIONAL ECONOMY 635
CHAPTER 19
Comparative advantage and the gains from
international trade 636
AN OVERVIEW OF INTERNATIONAL TRADE 638
THE IMPORTANCE OF TRADE TO THE
AUSTRALIAN ECONOMY 640
Australian international trade in a world context 640
• Making the connection 19.1
The iPhone is made in China . . . or is it? 641
COMPARATIVE ADVANTAGE IN INTERNATIONAL
TRADE 642
A brief review of comparative advantage 642
Comparative advantage and absolute advantage 642
HOW COUNTRIES GAIN FROM INTERNATIONAL
TRADE 643
Increasing consumption through trade 644
• Solved problem 19.1
The gains from trade 645
Why don’t we see complete specialisation? 646
Does anyone lose as a result of international
trade? 647
• Don’t let this happen to you
Remember that trade creates both winners and
losers 647
Where does comparative advantage come from? 647
GOVERNMENT POLICIES THAT RESTRICT
INTERNATIONAL TRADE 648
Tariffs 650
Quotas 651
Measuring the economic impact of the sugar quota 652
• Solved problem 19.2
Measuring the economic effect of a quota 652
Gains from unilateral elimination of tariffs
and quotas 654
Domestic support policies 654
Other barriers to trade 654
THE ARGUMENTS OVER TRADE POLICIES
AND GLOBALISATION 654
Why do some people oppose the World Trade
Organization? 655
Dumping 657
• Making the connection 19.2
The unintended consequences of banning goods
made with child labour 657
Radical environmentalism 658
Positive versus normative analysis (once again) 659
CONCLUSION 659
• An inside look
China-Australia Free Trade Agreement: outcomes at
a glance 660
CHAPTER SUMMARY AND PROBLEMS 662
CHAPTER 20
Macroeconomics in an open economy 668
THE BALANCE OF PAYMENTS: LINKING AUSTRALIA
TO THE INTERNATIONAL ECONOMY 670
The current account 670
The capital account 673
The financial account 674
Why is the balance of payments always zero? 674
• Don’t let this happen to you
Don’t confuse the balance of trade, the current
account balance and the balance of payments 675
• Solved problem 20.1
Understanding the arithmetic of open economies 675
THE FOREIGN EXCHANGE MARKET AND
EXCHANGE RATES 676
Equilibrium in the market for foreign exchange 677
• Don’t let this happen to you
Don’t confuse what happens when a currency
appreciates with what happens when it depreciates 678
How do shifts in demand and supply affect the
exchange rate? 679
Some exchange rates are not determined by the
market 680
• Making the connection 20.1
The Chinese yuan: the world’s most controversial
currency 681
How movements in the exchange rate affect exports
and imports 682
• Solved problem 20.2
The effect of changing exchange rates on the
prices of imports 683
The real exchange rate 683
EXCHANGE RATE SYSTEMS 684
THE CURRENT EXCHANGE RATE SYSTEM 686
The floating dollar 686
What determines exchange rates in the long run? 687
• Making the connection 20.2
The Big Mac theory of exchange rates 689
The four determinants of exchange rates in the
long run 689
• Making the connection 20.3
Greece and Germany: diverse economies,
common currency 690
THE INTERNATIONAL SECTOR AND NATIONAL
SAVING AND INVESTMENT 692
Current account balance equals net foreign
investment 692
Domestic saving, domestic investment and net
foreign investment 693
THE EFFECT OF A GOVERNMENT BUDGET
DEFICIT ON INVESTMENT 695
Is Australia’s current account deficit a problem? 695
• Making the connection 20.4
International debt relief for poor countries 697
MONETARY POLICY AND FISCAL POLICY IN AN
OPEN ECONOMY 698
Monetary policy in an open economy 698
Fiscal policy in an open economy 699
CONCLUSION 699
• An inside look
Brexit tipped to push $A higher, RBA to cut rate 700
CHAPTER SUMMARY AND PROBLEMS 702
Glossary 709
Index 716
 

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