Eco 101 textbook

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Douglas McTaggart

Christopher Findlay

Michael Parkin

MACROECONOMICS

SEVENTH EDITION

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DOUGLAS McTAGGART CHRISTOPHER FINDLAY MICHAEL PARKIN

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The Copyright Act 1968 of Australia allows a maximum of one chapter or 10% of this book, whichever is the greater, to be copied by any educational institution for its educational purposes provided that that educational institution (or the body that administers it) has given a remuneration notice to Copyright Agency Limited (CAL) under the Act. For details of the CAL licence for educational institutions contact:

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All rights reserved. Except under the conditions described in the Copyright Act 1968 of Australia and subsequent amendments, no part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner.

Editor in Chief: Frances Eden Senior Acquisitions Editor: Simone Bella Senior Project Editor: Rebecca Pomponio Manager – Product Development: Michael Stone Editorial Coordinator: Germaine Silva Production Controller: Barbara Honor Copy Editor: Felicity McKenzie Proofreader: Nicole Le Grand

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Printed in China 1 2 3 4 5 17 16 15 14 13 National Library of Australia Cataloguing-in-Publication Data Author: McTaggart, Douglas,

1953-Title: Macroeconomics / Douglas McTaggart, Christopher Findlay, Michael Parkin. Edition: 7th ed.

ISBN: 9781442550797 (pbk.) ISBN: 9781486003624 (Vital Source)

Notes: Includes index.

Subjects: Macroeconomics – Textbooks.

Other Authors/Contributors: Findlay, Christopher C. (Christopher Charles), Parkin, Michael, 1939-. Dewey Number: 339

Every effort has been made to trace and acknowledge copyright. However, should any infringement have occurred, the publishers tender their apologies and invite copyright owners to contact them. Due to copyright restrictions, we may have been unable to include material from the print edition of the book in this digital edition, although every effort has been made to minimise instances of missing content.

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Doug McTaggart

is recently retired as Chief Executive Officer of the

Queensland Investment Corporation (a fund manager with over $65 billion in assets under management). He was a student at the Australian National University, earned his PhD at the University of Chicago, and has held academic appointments at the Virginia Polytechnic Institute, the University of Adelaide and Bond University. He is a former Under Treasurer and Under Secretary of the Queensland Treasury, a past President of the Economic Society of Australia, a former member of the Australian Accounting Standards Board, and a former Chairman of the Investment and Financial Services Association (now Financial Services Council). Currently he is a Councillor on the National Competition Council and the Coag Reform Council. He is also a director on a number of listed and unlisted companies. Dr McTaggart’s research and publications spanned a wide area and cover macroeconomics, monetary theory, game theory and applied microeconomics.

Christopher Findlay

was educated at the University of Adelaide and the

Australian National University (ANU). He was Professor of Economics in the Asia Pacific School of Economics and Government at the ANU before moving in late 2005 to the University of Adelaide to become Professor of Economics and Head of the School of Economics. He is now Executive Dean of the University of Adelaide Faculty of the Professions. His chief interests are Australia’s economic links with Asia and international trade and investment in services, air transport in particular.

Michael Parkin

received his training as an economist at the Universities of

Leicester and Essex in England. He is Professor Emeritus in the Department of Economics at the University of Western Ontario, Canada. Professor Parkin has held faculty appointments at Brown University, the University of Manchester, the University of Essex and Bond University. He is a past president and fellow of the Canadian Economics Association and

has served on the editorial boards of theAmerican Economic Review and the Journal of

Monetary Economics and as managing editor of the Canadian Journal of Economics. Professor Parkin’s research on macroeconomics, monetary economics and international economics has resulted in over 160 publications in journals and edited volumes, including

theAmerican Economic Review , the Journal of Political Economy , the Review of Economic

Studies, the Journal of Monetary Economics, and the Journal of Money, Credit and Banking. He became most visible to the public with his work on inflation that discredited the use of wage and price controls. Michael Parkin also spearheaded the movement towards European monetary union.

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Dedications

Douglas McTaggart dedicates this book to Pam, Cameron, Lachlan and especially Andrew. Christopher Findlay dedicates this book to Tania, Marek and Kasia.

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ix

PART ONE

INTRODUCTION

1

CHAPTER 1 What Is Economics?1

CHAPTER 2 The Economic Problem 29

CHAPTER 3 Demand and Supply 51

PART FOUR

MONITORING MACROECONOMIC

PERFORMANCE

397

CHAPTER18 Measuring GDP and Economic Growth397

CHAPTER19 Monitoring Jobs and Inflation 421

PART FIVE

UNDERSTANDING THE

MACROECONOMY

443

CHAPTER20 Economic Growth 443

CHAPTER21 Finance, Saving and Investment 469

CHAPTER22 Money, the Price Level and Inflation

493

CHAPTER23 The Exchange Rate and the Balance of Payments519

CHAPTER24 Aggregate Supply and Aggregate Demand545

CHAPTER25 Expenditure Multipliers: The Keynesian

Model569

CHAPTER26 Australian Macroeconomic

Fluctuations599

PART SIX

MACROECONOMIC POLICY

621

CHAPTER27 Fiscal Policy621

CHAPTER28 Monetary Policy645

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The future is always uncertain

.

But at some times,

and now is one such time, the range of possible futures is enormous. As a small eco nomy tightl y integrated into the global economy, it is uncertainty about external forces that dominates Australia’s outlook.

There is uncertainty about monetary policy with the European Central bank and the U.S. Federal Reserve Bank holding interest rates at historical low s and injecting billions of dollars of money in an attempt to stimulate a flagging recovery from a global financial crisis. And there is extraordinary uncertainty about fiscal policy as budget deficits in the United States and Europe seem ever harder to control.

Whether or when economic growth in China and India will slow and dampen the growth of the rest of the world is a big unknown.

Since the global financial crisis of August 2007 moved economics from the business page of the news-paper to the front page, fear has gripped producers, consumers, financial institutions and governments.

Even the idea that the market is an efficient mecha-nism for allocating scarce resources came into ques-tion as some political leaders trumpeted the end of capitalism and the dawn of a new economic order in which tighter regulation reined in unfettered greed.

Rarely do teachers of economics have such a rich feast on which to draw. And rarely are the principles of economics more surely needed to provide the solid foundation on which to think about economic events and navigate the turbulence of economic life.

Although thinking like an economist can bring a clearer perspective to and a deeper understanding of today’s events, students don’t find the economic way of thinking easy or natural. Economics seeks to put clarity and understanding in the grasp of the student through its careful and vivid exploration of the tension between self-interest and the social interest, the role and power of incentives – of opportunity cost and marginal benefit – and the possibility that markets supplemented by other mechanisms might allocate resources efficiently.

McTaggart, Findlay and Parkin students begin to think about issues the way real economists do and learn how to explore difficult policy problems and make more informed decisions in their own lives.

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_{The Seventh Edition Revision}

Simpler where possible, stripped of some technical detail, more copiously illustrated with well-chosen photographs, reinforced with improved chapter sum-maries and problem sets, and even more tightly inte-grated with MyEconLab: These are the hallmarks of this seventh edition of Economics .

This comprehensive revision also incorporates and responds to the detailed suggestions for improve-ments made by reviewers and users, both in the broad architecture of the text and in each chapter. The revi-sion builds on the improvements achieved in previ-ous editions and retains its thorough and detailed presentation of the principles of economics, its emphasis on real-world examples and applications, its development of critical thinking skills, its diagrams renowned for pedagogy and precision and its path-breaking technology.

Most chapters have been fine-tuned to achieve even greater clarity and to present the material in a more straightforward, visual and intuitive way. Some chapters have been thoroughly reworked to cover new issues, particularly those that involve current policy problems. These changes are aimed at better enabling students to learn how to use the economic toolkit to analyse their own decisions and understand the events and issues they are confronted with in the media and at the ballot box.

Current issues organise each chapter.News stories about today’s major economic events tie a chapter together, from new, briefer chapter-opening questions to end-of-chapter problems and online practice. Each chapter includes a discussion of a critical issue of our time to demonstrate how economic theory can be applied to explore a particular debate or question.

Among the many issues covered are  The rising cost of food in Chapter 2  The fluctuating price of bananas and coffee in

Chapter 3

 Recession and unemployment in Chapters 18, 24 and 26

 Currency fluctuations and the managed Chinese yuan in Chapter 23

PREFACE

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 Fiscal stimulus and the debate about the fiscal stimulus multipliers in Chapter 27  Monetary stimulus in Chapter 28.

Real-world examples and applications appear in the body of each chapter and in the end-of-chapter problems and applications, which are available in MyEconLab for assignment as homework, quizzes or tests.

A selection of the questions that appear weekly in MyEconLab in Economics in the News is also available for assignment as homework, quizzes or tests.

Highpoints of the Revision

All the chapters have been updated to incorporate data to the second quarter of 2011 and the news and policy situation to the second quarter of 2012. And in addition to being thoroughly updated and revised to include the topics and features just described, the chapters feature the following nine notable changes: 1. What Is Economics? (Chapter 1): We have worked the explanation of the economic way of

thinking around six key ideas, all illustrated with student-relevant choices. The graphing appendix to this chapter has an increased focus on scatter diagrams and their interpretation and on understanding shifts of curves.

2. Measuring GDP and Economic Growth (Chapter 18): We have revised the section on cros s-country comparisons and the limitations of GDP to make the material clearer and we have added photo illustrations of purchasing power parity and of items omitted from GDP. A new appendix to this chapter explains the graphing of time-series data and the use of a ratio scale to reveal trends. The Mathematical Note on chain volume measure of GDP has been simplified.

3. Monitoring Jobs and Inflation(Chapter 19): This chapter now includes a discussion and illustration of the duration of unemployment spells. We have rewrit-ten the section on full employment and the influences on the natural unemployment rate. The coverage of the price level has been expanded to define and explain the costs of deflation as well as inflation.

4. Economic Growth (Chapter 20): We have simpli-fied this chapter by omitting the technical details on growth accounting and replacing them with an intu-itive discussion of the crucial role of human capital and intellectual property rights. We illustrate the role played by these key factors during Britain’s Industrial Revolution. We have made the chapter more relevant and empirical by including a summary of the correla-tions between the growth rate and the positive and negative influences on it.

5. Money, the Price Level and Inflation (Chapter 22): This chapter compares the Reserve Bank’s response to the global financial crisis with the U.S. Federal Reserve’s extraordinary injection of monetary base fol-lowing the financial panic of 2008.We have redrawn the line between this chapter, the ‘money and banking’ chapter, and the later ‘monetary policy’ chapter by including in this chapter a complete expla-nation of how an open market operation works. We have also provided clearer and more thorough expla-nations of the money multiplier and money market equilibrium in the short and the long run and in the transition to the long run.

6. The Exchange Rate and the Balance of Payments (Chapter 23): We have revised this chapter to better explain the distinction between the fundamentals and the role of expectations. We have also included an explanation of how arbitrage works in the foreign exchange market and the temporary and risky nature of seeking to profit from the so-called ‘carry trade’. 7. Aggregate Supply and Aggregate Demand (Chapter 24): We have revised the section of this chapter that explains the use of the AS - AD model to understand growth and inflation trends and business cycle fluctuations. W e have closely tied these explana-tions to the Australian data on economic growth, inflation and the business cycle with an emphasis on the most recent business cycle.

8. Fiscal Policy (Chapter 27): The topic of this chapter is front-page news almost every day and is likely to remain so. The revision describes the budget deficit and debt and explains the consequences of the uncertainty they engender. A thoroughly revised section examines the fiscal stimulus measures taken over the past year, channels through which the stimu-xii PREFACE

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PREFACE xiii

lus works, the unwanted side effects of the stimulus, its potentially limited power and its shortcomings. The chapter also examines the controversy about and range of views on the size of the fiscal stimulus multi-plier.

9. Monetary Policy (Chapter 28): This chapter describes and explains the monetary policy responses to the 2008–2009 recession and the persistent winds of 2010 and 2011. It also contains an improved description of the Reserve Bank’s decision-making process. Technical details about alternative monetary policy strategies have been replaced with a shorter and more focused discussion of this topic and the need to bring clarity and predictability to monetary policy to anchor inflation expectations.

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_{Features to Enhance Teaching}

and Learning

Reading Between the Lines

This McTaggart, Findlay and Parkin hallmark helps students think like economists by connecting chapter tools and concepts to the world around them. In Reading Between the Lines at the end of each chapter students apply the tools they have just learned by analysing an article from a newspaper or news website. Each article sheds additional light on the

questions first raised in the chapter opener. Questions about the article also appear with the end-of-chapter problems and applications.

Coffee Surges on Poor Colombian Harvests

FT.com 30 July 2010

Coffee prices hit a 12-year high on Friday on the back of low supplies of premium Arabica coffee from Colombia after a string of poor crops in the Latin American country. The strong fundamental picture has also encouraged hedge funds to reverse their previous bearish views on coffee prices.

In New York, … Arabica coffee jumped 3.2 per cent to 178.75 cents per pound, the highest since February 1998. It traded later at 177.25 cents, up 6.8 per cent on the week. The London-based International Coffee Organization on Friday warned that the ‘current tight demand and supply situation’ was ‘likely to persist in the near to medium term’. Coffee industry executives believe prices could rise towards 200 cents per pound in New York before the arrival of the new Brazilian crop later

this year.

‘Until October it is going to be tight on high quality coffee,’ said a senior executive at one of Europe’s largest coffee roasters. He said: ‘The industry has been surprised by the scarcity of high quality beans’. Colombian coffee production, key for supplies of premium beans, last year plunged to a 33-year low of 7.8 m bags, each of 60 kg, down nearly a third from 11.1 m bags in 2008, tight-ening supplies worldwide … Excerptedfrom ‘Coffee Surg es on PoorColombian Harvests’by Javier Blas,FinancialTimes . © The Financial Times Limited(2010). All rig hts reserved.

READING BETWEEN THE LINES

Demand and Supply: The Price of Coffee

The price of premium Arabica coffee increased by 3.2 per cent to almost 180 cents per pound in July 2010, the highest price since February 1998.

A sequence of poor crops in Colombia cut the production of premium Arabica coffee to a 33-year low of 7.8 million 60 kilogram bags, down from 11.1 million bags in 2008.

The International Coffee Organization said that the ‘current tight demand and supply situation’ was ‘likely to persist in the near to medium term’.

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

Hedge funds previously expected the price of coffee to fall but now expect it to rise further. ESSENCE OF THE STORY

Figure 2

Figure 2 T he Ef f ects o f the Expected Future P riceT he Ef f ects o f the Expected Future P rice D S 1

S 0

Figure 1 T he Ef f ects o f the C o lo mbian C ro p Figure 1 T he Ef f ects o f the C o lo mbian C ro p

Decrease in Colombian crop ... P r i c e ( c e n t s p e r p o u n d )

Quantity (millions of bags) 0 160 110116120 130 140 170 174 180 190 200 100 ... and decreases quantity ... raises price ...

Rise in expected future price increases demand and decreases supply ... P r i c e ( c e n t s p e r p o u n d )

Quantity (millions of bags) 0 160 110116120 130 140 170 180 190 200 210 220 230 100 ... and raises price further D 0 D 1 S 2 S 1 ECONOMIC ANALYSIS This news article reports two sources of changes in

supply and demand that changed the price of coff ee.

The first source of change is the sequence of poor harvests in Colombia. These events decreased the world supply of Arabica coffee. (Arabica is the type that Starbucks uses.)

Before the reported events, the world production of Arabica was 120 million bags per year and its price was 174 cents per pound.

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

Figure 1 shows the situation before the poor Colombian harvests and the effects of those poor harvests. The demand curve isD and initially the supply curve wasS 0. The market equilibrium is at 120 million bags per year and a price of 174 cents per pound.

The poor Colombian harvests decreased supply and the supply curve shifted leftward toS 1. The price increased to 180 cents per pound and the quantity decreased to 116 million bags.

The second source of change influenced both supply and demand. It is a change in the expected future price of coffee.

The hedge funds referred to in the news article are speculators that try to profit from buying at a low price and selling at a high price.

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

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

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

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Graphs That Show the Action

Through the past six editions, this book has set new standards of clarity in its graphs; the seventh edition continues to uphold this tradition. Our goal has always been to show ‘where the economic action is’. Our graphs continue to generate an enormously positive response, which confirms our view that graphical analysis is the most powerful tool available for teaching and learning economics.

Because many students find graphs hard to work with, we have developed the entire art program with

the study and review needs of the student in mind. The graphs feature

 Original curves consistently shown in blue  Shifted curves, equilibrium points and other

important features highlighted in red  Colour-blended arrows to suggest movement  Graphs paired with data tables

 Graphs labelled with boxed notes

 Extended captions that make each graph and its caption a self-contained object for study and review.

Chapter Objectives

Each chapter begins with a list of learning objectives, which enables students to see exactly where the chapter is going and to set their goals before they embark on their detailed study.

Chapter Openers

Each chapter opens with a carefully chosen photo-graph, question and student-friendly vignette designed to give students a quick sense of what the chapter is about and how it connects with their own economic world and experience. The chapter opening story is woven into the body of the chapter and explored further in the Reading Between the Lines feature that ends the chapter.

Economics in Action Boxes

This new feature addresses current events and eco-nomic occurrences that highlight and amplify the topics covered in the chapter. Instead of simply reporting the current events, the material applies the event to an economics lesson, enabling students to see how economics plays a part in the world around them as they read through the chapter.

Some of the many issues covered in this feature include the global market for crude oil, the best afford-able choice of movies and DVDs, the cost of selling a pair of shoes, how Apple doesn’t make the iPhone, the trends and cycles in real GDP and the price level, and the size of the fiscal stimulus multipliers.

xiv PREFACE Quantity Decrease in supply Increase in supply 0 Decrease in quantity supplied Increase in quantity supplied S 2 S 0 S 1 Economics in Action Economics in Action

The Global Market for Crude Oil The Global Market for Crude Oil The demand and supply model provides insights into all competitive markets. Here, we’ll apply what you’ve learned about the effects of an increase in demand to the global market for crude oil.

Crude oil is like the life-blood of the global economy. It is used to fuel our cars, aeroplanes, trains and buses, to generate electricity and to produce a wide range of plastics. When the price of crude oil rises, the costs of transportation, power and materials all increase.

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

While the price of oil was rising, the quantity of oil produced and consumed also increased. In 2001, the world produced 65 million barrels of oil a day. By 2008, that quantity was 72 million barrels.

Who or what has been raising the price of oil? Is it the action of greedy oil producers? Oil producers might be greedy and some of them might be big enough to withhold supply and raise the price, but it wouldn’t be in their self-interest to do so. The higher price would bring forth a greater quantity supplied from other producers and the profit of the producer limiting supply would fall.

Oil producers could try to cooperate and jointly withhold supply. The Organisation of Petroleum

Exporting Countries, OPEC, is such a group of pro-ducers. But OPEC doesn’t control theworld supply and its members’ self-interest is to produce the quanti-ties that give them the maximum attainable profit.

So even though the global oil market has some big players, they don’t fix the price. Instead, the actions of thousands of buyers and sellers and the forces of demand and supply determine the price of oil.

So how have demand and supply changed? Because both the price and the quantity have increased, the demand for oil must have increased. Supply might have changed too, but here we’ll suppose that supply has remained the same.

The global demand for oil has increased for one major reason: World income has increased. The increase has been particularly large in the emerging economies of China, India and Brazil. Increased world income has increased the demand for oil-using goods such as electricity, petrol and plastics, which in turn has increased the demand for oil.

The figure illustrates the effects of the increase in demand on the global oil market. The supply of oil remained constant along supply curveS . The demand for oil in 2001 wasD 2001, so in 2001 the price was $20 a barrel and the quantity was 65 million barrels per day. The demand for oil increased and by 2008 it had reachedD 2008. The price of oil increased to $127 a barrel and the quantity increased to 72 million barrels a day. The increase in the quantity is anincrease in the quantity supplied , not an increase in supply.

200 60 72 85 P r i c e ( 2 0 1 0 d o l l a r s p e r b a r r e l )

Quantity (millions of barrels per day) 65 127 20 40 0 60 80 100 140 160 180 80 S D 2001 D 2008 Rise in global incomes increases the demand for oil

T he Global Market f or Crude Oil T he Global Market f or Crude Oil

Price of oil rises ...

… and quantity of oil supplied increases

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PREFACE xv

Key Terms

Highlighted terms simplify the student’s task of learn-ing the vocabulary of economics. Each highlighted term appears in an end-of-chapter list with its page number, in an end-of-book glossary with its page number, bold-faced in the index, and in MyEconLab in the interactive glossary and flashcards.

End-of-Chapter Summary

Each chapter closes with a concise summary organised by major topics and list of key terms with page refer-ences. These learning tools provide students with a summary for review and exam preparation.

In-T

In-Text Review

ext Review Quizzes and

Quizzes and End-of-Chapter

End-of-Chapter

Problems and Applications

A Review Quiz at the end of each major section enables students to determine whether a topic needs further study before moving on, and Problems and Applications at the end of each chapter provide an opportunity to practise and apply the topics of the chapter.

All the Review Quizzes and end-of-chapter Problems and Applications are in the MyEconLab Study Plan (see p. xvi) where students can work them and receive instant feedback and explanations.



_{For the Lecturer}

This book enables you to focus on the economic way of thinking and choose your own course structure.

Focus on the Economic Way of Thinking

As a teacher, you know how hard it is to encourage a student to think like an economist. But that is your goal. Consistent with this goal, the text focuses on and repeatedly uses the central ideas: choice; tradeoff; opportunity cost; the margin; incentives; the gains from voluntary exchange; the forces of demand, supply and equilibrium; the pursuit of economic rent; the tension between self-interest and the social inter-est; and the scope and limitations of government actions.

Flexible Structure

You have preferences for how you want to teach your course. We have organised this book to enable you to do so. The flexibility chart on p. xix illustrate the

book’s flexibility. By following the arrows through the charts you can select the path that best fits your pref-erence for course structure. Whether you want to teach a traditional course that blends theory and policy, or one that takes a fast track through either theory or policy issues, Economics gives you the choice.

Supplemental Resources

All instructor supplements are available via: the Pearson catalogue page (www.pearson.com.au/9781442550773)  MyEconLab (www.pearson.com.au/mctaggart) Computerised Test Banks

Computerised Test BanksThe seventh edition test bank (Test Item File) with more than 3,000 multiple-choice questions has been prepared by Mark Dodd of the University of Adelaide and Tikiri Agalewatte of the University of Wollongong. Mark and Tikiri reviewed all existing questions to ensure their clarity and consis-tency with the seventh edition. New questions follow the style and format of the end-of-chapter text prob-lems and they provide the lecturer with a new set of testing opportunities and/or homework assignments. Test Item File questions are available in MyEconLab for instructors to use in a test, a quiz or as homework.

Pearson’s TestGen enables instructors to view and edit test bank questions, generate tests, and print them in a variety of formats. Search and sort functions make it easy to locate questions and arrange them in any order desired. TestGen also enables instructors to administer tests on a local area network, have tests graded electronically, and have the results prepared in electronic or printed reports.

Pearson TestGen is compatible with Windows or Macintosh systems.

Solutions Manual

Solutions ManualFor ease of use and instructor refer-ence, a comprehensive Solutions Manual provides lecturers with detailed solutions to the Review Quizzes and the end-of-chapter Study Plan Problems and Applications and Additional Problems and Applications. John Snelling of the University of Adelaide has prepared the Solutions Manual. For an

electronic version of the Solutions Manual go to www.pearson.com.au/9781442550773.

PowerPoint Resources

PowerPoint ResourcesRobin Bade has developed the full-colour Microsoft PowerPoint Lecture Presen -tation for each chapter, which includes animated

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versions of the textbook figures, tables from the text-book and speaking notes.

A separate set of PowerPoint files containing large-scale animated versions of all the textbook’s figures and the tables from the text is available. Use the presentations electronically in the classroom or printed to create hard-copy transparency masters. This item is available for Macintosh and Windows. Instructor’s Resource Centre

Instructor’s Resource CentreLecturers can download supplements from a secure, instructor-only source at www.pearson.com.au/9781442550773.

MyEconLab

MyMyEconEconLabLab

MyEconLab’s assessment and tutorial system works hand-in-hand with Economics . With comprehensive homework, quiz, test and tutorial options, lecturers can manage all assessment needs in one program.  All of the Review Quiz questions and

end-of-chapter Problems and Applications are assignable and automatically graded.

 Students can work the Review Quiz questions and end-of-chapter Study Plan Problems and Applications as part of the MyEconLab Study Plan.  Instructors can assign the end-of-chapter

Additional Problems and Applications as autograded assignments. These Problems and Applications are not available to students in

MyEconLab unless assigned by the instructor.  Many of the Problems and Applications are

algorithmic, draw-graph and numerical exercises.  Test Item File questions are available for

assignment as homework.

 The Custom Exercise Builder gives instructors the flexibility of creating their own problems for assignment.

 The Gradebook records each student’s performance and the time spent on Tests, Study Plan and Homework and generates reports by student or by chapter.

 Economics in the Newsis a turn-key solution to bringing daily news into the classroom. Updated weekly during the academic year, we upload two

relevant articles (one micro, one macro) and provide links for further information and questions that may be assigned for homework or for classroom discussion.

 A suite of ABC News (U.S.) videos, which address current topics such as education, energy, U.S. Federal Reserve policy and business cycles, is available for classroom use. Video-specific exercises are available for instructor assignment.

Michael Parkin and Robin Bade, assisted by Jeannie Gillmore and Laurel Davies, author and

oversee all of the MyEconLab content for Economics . Our peerless MyEconLab team has worked hard to ensure that it is tightly integrated with the book’s content and vision. For more information go to www.pearson.com.au/mctaggart.

Experiments in MyEconLab

Experiments are a fun and engaging way to promote active learning and mastery of important economic concepts. Pearson’s experiments program is flexible and easy for lecturers and students to use.

 Single-player experiments allow your students to play against virtual players from anywhere at any time with an Internet connection.  Multiplayer experiments allow you to assign and

manage a real-time experiment with your class. Pre- and post-questions for each experiment are available for assignment in MyEconLab.



_{For the Student}

With this textbook, you get access to some powerful learning tools.

MyEconLab

MyMyEconEconLabLab

MyEconLab’s tutorial system provides lots of opportu-nities to practise and review what you are learning.  Take a ‘Sample Test’ to create your personalised

‘Study Plan’.

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

 Use the ‘Help Me Solve This’ problem tools when you need extra help.

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PREFACE xvii

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

 Use the ‘Ask the Authors’ tool to send an email to the authors and get help when you need it. Registering for MyEconLab with an access card Registering for MyEconLab with an access card If your textbook came bundled with a MyEconLab access code, refer to the card for registration instruc-tions.

Purchasing access

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

Study on the Go

At the end of each chapter, you will find a unique QR code providing access to Study on the Go, an unprece-dented mobile integration between text and online content. You can link to Pearson’s unique Study on the Go content directly from your smartphone, allow-ing you to study whenever and wherever you wish! Go to one of the sites below to see how you can download an app to your smartphone for free. Once the app is installed, scan the code and your phone will link to a website containing Pearson’s Study on the Go content,_{including the popular study tools: glossary, flashcards,} audio summaries and multiple-choice quizzes, which can be accessed at any time.

ScanLife: http://get.scanlife.com NeoReader: http://get.neoreader.com QuickMark: http://www.quickmark.com.tw

PowerPoint Lecture Notes

Robin Bade has developed the full-colour Microsoft PowerPoint Lecture Notes for each chapter, which include animated versions of the textbook figures. Take these notes to class and edit them to create your own personal summary for review.

VitalSource Edition

VitalSource is an electronic version of the text to fit your mobile lifestyle. Download it to your computer and search for key concepts, words and phrases, make highlights and notes as you study and share your notes with your friends.



_{Acknowledgements}

As we said in earlier editions, one of the great pleas-ures of writing an introductory text is the opportunity it affords to learn from so many generous friends and colleagues. Although the extent of our debt cannot be fully acknowledged here, it is nevertheless a joy to record our gratitude to the many people who have helped, some without realising just how helpful they have been.

We thank our many exceptional reviewers whose names are listed on the following pages. Many of them spent much more time than we could have reasonably expected and provided detailed comments on drafts of the manuscript. Their comments and suggestions have been extremely helpful and we have made every attempt to heed their advice.

We thank the several thousand students whom we have been privileged to teach. The instant response that comes from the look of puzzlement or enlighten-ment has taught us how to teach economics.

We also thank Doon-Louise Williams and David Tucker, students at Griffith University, for pointing out an error in the sixth edition.

We thank Richard Parkin for his work on the elec-tronic art manuscript, the PowerPoint animations and the Flash animations of the figures in the e-text on MyEconLab. We thank Jeannie Gillmore and Laurel Davies for creating and managing our evergrowing and ever more complex MyEconLab database. We also thank John Snelling of the University of Adelaide for helping with news-based end-of-chapter problems and applications.

Finally, we are deeply grateful to the editorial team at Pearson Australia. Vision, energy, enthusiasm, pro-fessionalism, flair and commitment are just some of the characteristics of the team. Editor in Chief Frances Eden, Manager – Product Development Michael Stone, Senior Acquisitions Editor Simone Bella, Senior Project Editor Rebecca Pomponio and Editorial Coordinator Germaine Silva have again confirmed with this new edition their reputation as Australia’s

finest academic publishers. They have built a culture that brings out the best in their editors and authors.

They have been supported by Copyright and Pictures Editor Lisa Woodland, copy editor Felicity McKenzie, proofreader Nicole Le Grand and typeset-ter Leonie Ryan. We are grateful for their commitment to the project and their excellent attention to detail.

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Classroom experience will test the value of this book. We would appreciate hearing from instructors and students about how we can continue to improve it in future editions.

Douglas McTaggart

Queensland Investment Corporation email: [email protected] Christopher Findlay University of Adelaide

email: [email protected] Michael Parkin

University of Western Ontario email: [email protected]



_{Reviewers of the Seventh Edition}

Rod Duncan, Charles Sturt University Richard Dutu, Deakin University Catherine Fletcher, Monash University Peter Harkness, Swinburne University Yolanta Kwiecien, Monash University Paul Morris, University of Newcastle Munirul Nabin, Deakin University Peter Schuwalow, Monash University

Zulfan Tadjoeddin, University of Western Sydney



_{Reviewers of the Sixth Edition}

Jayanath Ananda, La Trobe University Siobhan Austen, Curtin Business School Carol Barry, Swinburne University of Technology John Bevacqua, Charles Sturt University

Jonathan Boymal, Royal Melbourne Institute of Technology

Mark Buchanek, Deakin University Bob Catley, University of Newcastle Bronwyn Coate, Royal Melbourne Institute of

Technology

Maxine Darnell, University of New England Sinclair Davidson, Royal Melbourne Institute of

Technology

Catherine Fletcher, Monash University Gigi Foster, University of South Australia Chris Gellar, Deakin University Mary Graham, Deakin University

Branka Krivokapic-Skoko, Charles Sturt University Yun-Lok Lee, Southern Cross University

Elizabeth Manning, Deakin University Ann Marsden, University of Tasmania

Stephen Mason, Southern Cross University Pundarik Mukhopadhaya, Macquarie University Muni Perumal, University of Canberra Ella Reeks, University of Tasmania John Rice, University of Adelaide

Graham Richards, Trinity College, University of Melbourne

Sveta Risman, Royal Melbourne Institute of Technology

Ali Saleh, University of Wollongong Pasquale Sgro, Deakin University Baljit Singh, La Trobe University Hazbo Skoko, Charles Sturt University Sam Tang, University of Western Australia Mehmet Ulubasoglu, Deakin University Spiro George Vlachos, University of Adelaide Mark Weder, University of Adelaide xviii PREFACE

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Chapter 19 Monitoring Jobs and Inflation Chapter 18 Measuring GDP and Economic Growth Chapter 24 Aggregate Supply and

Aggregate Demand

Chapter 22 Money, the Price Level

and Inflation

Chapter 23 The Exchange Rate and the Balance of Payments

Chapter 25 Expenditure Multipliers:

The Keynesian Model Chapter 21 Finance, Saving and Investment Chapter 20 Economic Growth Chapter 26 Australian Macroeconomic Fluctuations Chapter 27 Fiscal Policy Chapter 28 Monetary Policy

Macro Flexibility

SSttaarrt hheerre t ...e … … tthheen jjuumn mp ttoop any of these … any of these …

… and jump to any of these after … and jump to any of these after doing the prerequisites indicated doing the prerequisites indicated Chapter 1

What Is Economics?

Chapter 2 The Economic Problem

Chapter 3 Demand and Supply

xix

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PART ON E

INTRODUCTION

1 CHAPTER

CHAPTER

1 

_WHA

_{WHAT IS ECONOMICS?}

_{T IS ECONOMICS?}

₁

Definition of Economics 2

Two Big Economic Questions 3

What, How and for Whom? 3 Can the Pursuit of Self-Interest Promote

the Social Interest? 5

The Economic Way of Thinking 8

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

Economics as Social Science and Policy Tool 10

Economist as Social Scientist 10 Economist as Policy Adviser 10 Summary 11

Study Plan Problems and Applications 12 Additional Problems and Applications 12 APPENDIX

APPENDIX

Graphs in Economics

13 Graphing Data 13

Scatter Diagrams 14

Graphs Used in Economic Models 16

Variables That Move in the Same Direction 16 Variables That Move in Opposite Directions 17 Variables That Have a Maximum or a

Minimum 18

Variables That Are Unrelated 19

The Slope of a Relationship 20

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

Graphing Relationships Among More Than

Two Variables 22

Ceteris Paribus 22

When Other Things Change 23 MA

MATHEMATICAL NOTHEMATICAL NOTETE

Equations of Straight Lines

24

A Linear Equation 24 Slope of Line 24 Position of Line 25 Positive Relationships 25 Negative Relationships 25 Example 25 Summary 26

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

xxi

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CHAPTER 2



_{THE ECONOMIC PROBLEM}

₂₉

Production Possibilities and Opportunity Cost 30

Production Possibilities Frontier 30 Production Efficiency 31 Tradeoff Along thePPF 31 Opportunity Cost 31

Using Resources Efficiently 33

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

Economic Growth 36

The Cost of Economic Growth 36 A Nation’s Economic Growth 37

Gains f rom Trade 38

Comparative Advantage and Absolute Advantage 38

Achieving the Gains from Trade 39

Economic Coordination 41

Firms 41 Markets 42 Property Rights 42 Money 42

Circular Flows Through Markets 42 Coordinating Decisions 42

The Rising Opportunity Cost of Food 44 Summary 46

Study Plan Problems and Applications 47 Additional Problems and Applications 49

CHAPTER 3



_{DEMAND AND SUPPLY}

₅₁

Markets and Prices 52

Demand 53

The Law of Demand 53

Demand Curve and Demand Schedule 53 A Change in Demand 54

A Change in the Quantity Demanded Versus a Change in Demand 56

Supply 58

The Law of Supply 58

Supply Curve and Supply Schedule 58 A Change in Supply 59

A Change in the Quantity Supplied Versus a Change in Supply 60

Market Equilibrium 62

Price as a Regulator 62 Price Adjustments 63

Predicting Changes in Price and Quantity 64

An Increase in Demand 64 A Decrease in Demand 64 An Increase in Supply 66 A Decrease in Supply 66

All the Possible Changes in Demand and Supply 68

Demand and Supply: The Price of Coffee 70 MA

Demand, Supply and Equilibrium

72

Demand Curve 72 Supply Curve 72 Market Equilibrium 73 An Example 73 Summary 74

Study Plan Problems and Applications 75 Additional Problems and Applications 77 xxii CONTENTS

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PART FOUR

MONITORING MACROECONOMIC

PERFORMANCE

397

CHAPTER 18



_{MEASURING GDP AND}

ECONOMIC GROWTH

397 Gross Domestic Product 398

GDP Defined 398

GDP and the Circular Flow of Expenditure and Income 399

Why Is Domestic Product ‘Gross’? 400

Measuring Australia’s GDP 401

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

The Uses and Limitations of Real GDP 404

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

Real GDP Shows Slowing Economy 410

APPENDIX

Graphs in Macroeconomics

412 The Time-Series Graph 412

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

Using a Ratio Scale 413 MA

Chain Volume Measure of Real GDP

_{Value Production in Prices of Adjacent Years 414}

414

Find the Average of Two Percentage Changes 414 Link (Chain) to the Base Year 415

Exercise 415 Summary 416

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CHAPTER 19



_{MONITORING JOBS AND}

INFLATION

421 Employment and Unemployment 422

Why Unemployment Is a Problem 422 Labour Force Survey 423

Three Labour Market Indicators 423 Other Definitions of Underutilised Labour 425 All Underutilised Labour 426

Unemployment and Full Employment 427

_{Frictional Unemployment 427}

Structural Unemployment 427 Cyclical Unemployment 427 ‘Natural’ Unemployment 428 Real GDP a nd Unemployment Over the

Cycle 428

The Changing Natural Unemployment Rate 429

The Price Level, Inflation and Deflation 430

Why Inflation and Deflation Are Problems 430 The Consumer Price Index 431

Reading the CPI Numbers 431 Constructing the CPI 431 Measuring the Inflation Rate 432 Distinguishing High Inflation from a

High Price Level 433 The Biased CPI 433 The Magnitude of the Bias 434 Some Consequences of the Bias 434 Alternative Price Indexes 434

Core Inflation 435

The Real Variables in Macroeconomics 435

The Australian Labour Market 436 Summary 438

PART FIVE

UNDERSTANDING THE

MACROECONOMY

443

CHAPTER 20



_{ECONOMIC GROWTH}

₄₄₃

The Basics of Economic Growth 444

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

Economic Growth Trends 446

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

How Potential GDP Grows 449

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

Why Labour Productivity Grows 454

Preconditions for Labour Productivity Growth 454

Physical Capital Growth 455 Human Capital Growth 455 Technological Advances 455

Growth Theories, Evidence and Policies 457

Classical Growth Theory 457 Neoclassical Growth Theory 457 New Growth Theory 458

New Growth Theory Versus Malthusian Theory 460

Sorting Out the Theories 460

The Empirical Evidence on the Causes of Economic Growth 460

Policies for Achieving Faster Growth 460

Productivity and Real GDP 462 Summary 464

Study Plan Problems and Applications 465 Additional Problems and Applications 467 xxiv CONTENTS

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CHAPTER 21



_{FINANCE, SAVING AND}

INVESTMENT

469 Financial Institutions and Financial Markets 470

Finance and Money 470

Physical Capital and Financial Capital 470 Capital and Investment 470

Wealth and Saving 470

Financial and Capital Markets 471 Financial Institutions 472 Insolvency and Illiquidity 473 Interest Rates and Asset Prices 474

The Loanable Funds Market 474

Funds That Finance Investment 474 The Real Interest Rate 475

The Demand for Loanable Funds 476 The Supply of Loanable Funds 477

Equilibrium in the Loanable Funds Market 478 Changes in Demand and Supply 478

Government in the Loanable Funds Market 481

A Government Budget Surplus 481 A Government Budget Deficit 481

The Global Loanable Funds Market 483

International Capital Mobility 483 International Borrowing and Lending 483 Demand and Supply in the Global and

National Markets 483

Euro Crisis and the Global Market 486 Summary 488

CHAPTER 22



_{MONEY, THE PRICE LEVEL}

AND INFLA

AND INFLATION

TION

493 What Is Money? 494

Medium of Exchange 494 Unit of Account 494 Store of Value 495

Money in Australia Today 495

The Banking System 497

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

How Banks Create Money 501

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

The Money Market 504

The Influences on Money Holding 504 The Demand for Money 505

Shifts in the Demand for Money Curve 505 Money Market Equilibrium 506

The Quantity Theory of Money 508

The Cost of Bank Regulation 510 MA

The Money Multiplier

512

The Australian Money Multiplier 513 Summary 514

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CHAPTER 23



_{THE EXCHANGE RATE}

AND

AND THE BALANCE OF

THE BALANCE OF

PAYMENTS

519 The Foreign Exchange Market 520

Trading Currencies 520 Exchange Rates 520

Questions About the Australian Dollar Exchange Rate 520

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

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

Exchange Rate Fluctuations 525

A Change in Demand for Australian Dollars 525 A Change in Supply of Australian Dollars 526

Changes in the Exchange Rate 526

Fundamentals, Expectations and Arbitrage 528 The Real Exchange Rate 529

Exchange Rate Policy 530

Flexible Exchange Rate 530 Fixed Exchange Rate 530 Crawling Peg 531

Financing International Trade 533

Balance of Payments Accounts 533 Borrowers and Lenders 535 Debtors and Creditors 535

Is International Borrowing a Problem? 535 Current Account Balance 536

Net Exports 536

Where Is the Exchange Rate? 537

China’s Exchange Rate Policy 538 Summary 540

CHAPTER 24



_AGGREGA

_{AGGREGATE SU}

_{TE SUPPLY AND}

_{PPLY AND}

AGGREGA

AGGREGATE DEMAND

TE DEMAND

545 Aggregate Supply 546

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

Aggregate Demand 550

The Aggregate Demand Curve 550 Changes in Aggregate Demand 551

Explaining Macroeconomic Trends and

Fluctuations 554

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

AS - AD Model 555

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

Macroeconomic Schools of Thought 560

The Classical View 560 The Keynesian View 560 The Monetarist View 561 The Way Ahead 561

Aggregate Supply and Aggregate Demand in Action 562

Summary 564

Study Plan Problems and Applications 565 Additional Problems and Applications 567 xxvi CONTENTS

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CHAPTER 25



_{EXPENDITURE MULTIPLIERS:}

THE KEYNESIAN MODEL

569 Fixed Prices and Expenditure Plans 570

Expenditure Plans 570

Consumption and Saving Plans 570

Marginal Propensities to Consume and Save 572 Slopes and Marginal Propensities 572

Consumption as a Function of Real GDP 573 Import Function 573

Real GDP with a Fixed Price Level 574

Aggregate Planned Expenditure 574 Actual Expenditure, Planned Expenditure

and Real GDP 575 Equilibrium Expenditure 576 Convergence to Equilibrium 577

The Multiplier 578

The Basic Idea of the Multiplier 578 The Multiplier Effect 578

Why Is the Multiplier Greater Than 1? 579 The Size of the Multiplier 579

The Multiplier and the Slope of the AE Curve 580

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

The Multiplier and t he Price Level 583

Adjusting Quantities and Prices 583 Aggregate Expenditure and Aggregate

Demand 583

Deriving the Aggregate Demand Curve 583 Changes in Aggregate Expenditure and

Aggregate Demand 584

Equilibrium Real GDP and the Price Level 585

Changes in Expenditure Plans 588 MA

The Algebra of the Keynesian Model

590

Aggregate Expenditure 590 Equilibrium Expenditure 591 The Multiplier 591

Government Expenditure Multiplier 592 Autonomous Tax Multiplier 592

Balanced Budget Multiplier 593 Summary 594

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CHAPTER 26



_AUSTRALIAN

MACROECONOMIC

FLUCTUATIONS

599 Inflation Cycles 600

Demand-Pull Inflation 600 Cost-Push Inflation 602 Expected Inflation 604 Forecasting Inflation 605

Inflation and the Business Cycle 605

Inflation and Unemployment:

The Phillips Curve 606

The Short-Run Phillips Curve 606 The Long-Run Phillips Curve 607

Changes in the Natural Unemployment Rate 607

The Business Cycle 609

Mainstream Business Cycle Theory 609 Real Business Cycle Theory 610

Inflation Expectations 614 Summary 616

PART SIX

MACROECONOMIC POLICY

621

CHAPTER 27



_{FISCAL POLICY}

₆₂₁

Government Budgets 622

Budget Making 622

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

Supply-Side Effects of Fiscal Policy 628

Full Employment and Potential GDP 628 The Effects of the Income Tax 628

Taxes on Expenditure and the Tax Wedge 629 Taxes and the Incentive to Save and Invest 630 Tax Revenues and the Laffer Curve 631 The Supply-Side Debate 631

Fiscal Stimulus 632

Automatic Fiscal Policy and Cyclical and Structural Budget Balances 632 Discretionary Fiscal Stimulus 633

Swan’s Fiscal Policy 638 Summary 640

Study Plan Problems and Applications 641 Additional Problems and Applications 643 xxviii CONTENTS

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CHAPTER 28



_{MONETARY POLICY}

₆₄₅

Monetary Policy Objectives and

Framework 646

Monetary Policy Objective 646 Statement on the Conduct of Monetary

Policy 646 Actual Inflation 646

Responsibility for Monetary Policy 647

The Conduct of Monetary Policy 648

_{The Monetary Policy Instrument 648}

The Bank’s Interest Rate Decision 649 Hitting the Cash Rate Target 649

Monetary Policy Transmission 651

Quick Overview 651 Interest Rate Changes 651 Exchange Rate Fluctuations 652 Money and Bank Loans 653 The Long-Term Real Interest Rate 653 Expenditure Plans 653

The Change in Aggregate Demand, Real GDP and the Price Level 654

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

Extraordinary Monetary Stimulus 659

The Key Elements of the Crisis 659 The Policy Actions 660

Painfully Slow Recovery 660 Policy Strategies and Clarity 660

The Reserve Bank Fights Recession in 2011 662 Summary 664

Glossary G1 Index I1

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Copyright holders for the photos used in this book are shown below.

Chapter 1

Chapter 2

29© Kadmy | Dreamstime.com; 32 Barbara Reddoch | Dreamstime.com; 41 (left) © Bloomberg via Getty Images; (right) © David R. Frazier Photolibrary, Inc. | Alamy.

Chapter 3

Chapter 18

Images. Chapter 19

Chapter 21

Chapter 22

493George M. | Fotolia. Chapter 23

545© redbrickstock.com | Alamy; 552 (column 1) (left) Bloomberg via Getty Images; (right) AAP IMAGE; (column 2) (top left) Getty Images; (top right) Bloomberg via Getty Images; (bottom left) Bloomberg via Getty Images; (bottom right) Bloomberg via Getty Images. Chapter 25

569 Bloomberg via Getty Images. Chapter 26

Chapter 27

621© Phillip Minnis | Alamy; 637 (top) Roll Call | Getty Images; (middle) © Robert J. Barro; (bottom) © Estate of Mischa Richeter and Harald Bakken.

Chapter 28

xxxi

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You are studying economics at a time of enormous challenge and

change. Every day, new businesses are born and old ones die; new

jobs are created and old ones disappear. Nations, businesses, and

individuals must find ways of coping with economic change.

Your

life will be shaped by the challenges that

you

face and the

opportunities that

you

create. But to face those challenges and

seize the opportunities they present, you must understand the

powerful forces at play. The economics that you’re about to learn

will become your most reliable guide. This chapter gets you

started. It describes the questions that economists try to answer

and the ways in which they think as they search for the answers.

1

After studying this chapter

After studying this chapter, you will be able to, you will be able to

Define economics and distinguish between

microeconomics and macroeconomics

Explain the two big questions of economics Explain the key ideas that define the

economic way of thinking

Explain how economists go about their work

as social scientists and policy advisers

What Is

Economics?

CHAPTER

1

(35)

2 CHAPTER 1 What Is Economics?



_{Definition of Economics}

A fundamental fact dominates our lives: We want more than we can get. Our inability to get everything we want is calledscarcity scarcity . Scarcity is universal. It

con-fronts all living things. Even parrots face scarcity!

Because we can’t get everything we want, we must make choices . You can’t affordboth a laptop and an iPhone, so you mustchoose which one to buy. You can’t spend tonight both studying for your next test and going to the movies, so again, you must choose which one to do. The government can’t spend a tax dollar on both national defence and environmental protection, so it must choose how to spend that dollar.

Your choices must somehow be made consistent with the choices of others. If you choose to buy a

laptop, someone else must choose to sell it. Incentives reconcile choices. Anincentiveincentiveis a reward that encour-ages an action or a penalty that discourencour-ages one. Prices act as incentives. If the price of a laptop is too high, more will be offered for sale than people want to buy. And if the price is too low, fewer will be offered for sale

than people want to buy. But there is a price at which choices to buy and sell are consistent.

Economics

Economicsis the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcityand the incentives that influence and reconcile those choices.

The subject of economics has two parts:  Microeconomics

 Macroeconomics Microeconomics

Microeconomicsis the study of the choices that indi-viduals and businesses make, the way these choices interact in markets, and the influence of governments. Some examples of microeconomic questions are: Why are people downloading more movies? How would a tax on e-commerce affect eBay?

Macroeconomics

Macroeconomicsis the study of the performance of the national economy and the global economy. Some examples of macroeconomic questions are: Why did the unemployment rate fall last year? Why has Japan’s economy stagnated? Can the Reserve Bank bring prosperity by keeping interest rates low?

Not only do I want a cracker – we all want a cracker!

The New Yorker Collection | www.cartoonbank.com

Think about the things that you want and the scarcity that you face. You want to live a long and healthy life. You want to go to a good university. You want to live in a well-equipped, spacious, and

com-fortable home. You want the latest smart phone and a faster Internet connection for your laptop or iPad. You want some sport and recreational gear – perhaps some new running shoes, skis or a new bike. And you want more time, much more than is available, to go to lec-tures, do your homework, play sports, read novels, go to the movies, listen to music, travel, and hang out with your friends.

What you can afford to buy is limited by your income and by the prices you must pay. And your time is limited by the fact that your day has 24 hours. You want some other things that only governments provide. You want to live in a peaceful and secure world and a safe neighbourhood and enjoy the

bene-fits of clean air and water.

What governments can afford is limited by the taxes they collect. Taxes lower people’s incomes and compete with the other things they want to buy.

What everyone can get – what society can get – is limited by the productive resources available. These resources are the gifts of nature, human labour and ingenuity, and all the previously produced tools and equipment.

REVIEW QUIZ

1

1 List some examples of the scarcity that you face. 2

2 Find examples of scarcity in today’s headlines. 3

3 Find an example that illustrates the distinction between microeconomics and macroeconomics in today’s headlines.

You can work these questions in Study Plan 1.1 and get instant feedback.

My MyEconEconLabLab