Macroeconomics: Understanding the Wealth of Nations, 2Nd Edition
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ffirs-uk.qxd 12/8/04 12:20 pm Page i Government Spending Percent of Nominal, GDP Highest Inflation (%) Annual Average, 1990–2003 Rep. of Korea Ireland Congo, Dem. Rep. 2478.7 U.S. Australia Georgia 1655.8 Japan Armenia 837.8 Spain Nicaragua 788.3 New Zealand Canada Angola 770.8 Turkey Turkmenistan 748.5 Czech Rep. Ukraine 615.7 U.K. Iceland Brazil 613.2 Luxembourg Peru 569.6 Greece Belarus 489.5 Poland Kazakhstan 445.0 Portugal Slovak Rep. Tajikistan 415.6 Hungary Azerbaijan 345.1 Norway Uzbekistan 283.2 Italy Netherlands Russia 280.6 Germany Moldova 213.4 Finland Croatia 192.9 Belgium Austria Kyrgyz Republic 191.4 France Argentina 183.4 Denmark Macedonia 178.3 Sweden 0 10203040506070Source: IMF, World Economic Outlook Database (June, 2004). Source: World Bank, World Development Indicators (2003). Stock Markets’ Capitalizations ($mn 2003) Lowest Inflation (%) Annual Average, 1990–2003 Netherlands 413.09 Emerging Markets New Zealand 19.30 1,284.99 6% Belize Ϫ1.03 Norway 37.11 Argentina 2.40 Saudi Arabia 0.55 Portugal 32.17 Brazil 90.35 Sweden 194.98 Japan 0.65 Chile 20.87 Bahrain 0.68 China 51.40 Colombia 1.02 Oman 0.93 Czech Rep 4.02 Panama 1.12 U.S. Bosnia and Herzegovina 1.2 10,904.05 Egypt 2.78 52% Hong Kong 236.31 Brunei Dar 1.56 Hungary 9.90 Singapore 1.56 Indonesia 13.78 Dominica 1.86 India 47.42 France 1.91 Israel 30.35 South Korea 207.42 Switzerland 1.93 Japan Malaysia 52.04 Austria 2.03 1,781.85 Morocco 1.30 Belgium 2.07 9% Mexico 82.60 Germany 2.12 U.K. Greece 37.00 Pakistan 2.45 Taiwan 2.14 Ireland 53.85 2,040.68 Peru 3.23 10% Finland 2.2 Italy 342.33 Philippines 4.30 Poland 10.22 Denmark 2.22 Russia 46.59 Canada 2.31 Australia 420.84 Canada 472.61 France 831.25 South Singapore 72.21 Luxembourg 2.32 Austria 16.94 Denmark 58.78 Germany 620.42 Africa Thailand 21.81 Belgium 83.58 Finland 129.63 Spain 309.87 1% Turkey 13.53 Source: IMF, World Economic Outlook Database (June, 2004). Switzerland 594.22 Taiwan 256.69 Source: The Financial Times (January, 2004). ffirs-uk.qxd 12/8/04 12:20 pm Page ii ffirs-uk.qxd 12/8/04 12:20 pm Page iii MACROECONOMICS UNDERSTANDING THE WEALTH OF NATIONS ffirs-uk.qxd 12/8/04 12:20 pm Page iv ffirs-uk.qxd 12/8/04 12:20 pm Page v SECOND EDITION MACROECONOMICS UNDERSTANDING THE WEALTH OF NATIONS David Miles Professor of Finance The Tanaka Business School Imperial College London Andrew Scott Professor of Economics London Business School London John Wiley & Sons, Inc. v ffirs-uk.qxd 12/8/04 12:20 pm Page vi PUBLISHER Steve Hardman ASSOCIATE PUBLISHER Judith R. Joseph PROJECT EDITOR Cindy Rhoads SENIOR EDITORIAL ASSISTANT Jessica Bartelt SENIOR PRODUCTION EDITOR Valerie A. Vargas MARKETING MANAGER David Woodbury NEW MEDIA EDITOR Allison Morris TEXT and COVER DESIGNER Madelyn Lesure COVER CREDIT Chapter openers and back cover (abacus): ᭧ Masataka Yamakita/Photonica Front Cover (bridge): ᭧ David Noble/Taxi/Getty Images PRODUCTION SERVICES mb editorial services Copyright © 2005 John Wiley & Sons, Ltd, The Atrium, Southern Gate Chichester, West Sussex, PO19 8SQ, England Telephone: (+44) 1243 779777 Email (for orders and customer service enquires): [email protected] Visit our Home Page on www.wileyeurope.com or www.wiley.com All Rights Reserved. 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, scanning or otherwise, except under the terms of the Copyright, Designs and Patent Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, W1T 4LP, UK, without the permission in writing of the Publisher. Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons, Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, England, or e-mailed to [email protected], or faxed to (+44) 1243 770620. ISBN 0-470-86892-9 Typeset in 9.5/12 pt Times Ten Roman by GGS Book services, Atlantic Highlands, USA. Printed and bound in Great Britain by Martins the Printers, Berwick-upon-Tweed, Northumberland. This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production. 10987654321 ftoc.qxd 10/8/04 12:50 pm Page vii BRIEF CONTENTS INTRODUCTION CHAPTER 1 What Is Macroeconomics? 1 CHAPTER 2 The Language of Macroeconomics: The National Income Accounts 13 ECONOMIC GROWTH AND THE SUPPLY SIDE CHAPTER 3 The Wealth of Nations—The Supply Side 34 CHAPTER 4 Capital Accumulation and Economic Growth 59 CHAPTER 5 Total Factor Productivity, Human Capital, and Technology 86 CHAPTER 6 Endogenous Growth and Convergence 113 CHAPTER 7 Unemployment and the Labor Market 137 CHAPTER 8 International Trade 166 CHAPTER 9 Globalization 193 MONEY AND TAXES CHAPTER 10 Fiscal Policy and the Role of Government 224 CHAPTER 11 Money and Prices 257 BUSINESS CYCLES AND ECONOMIC POLICY CHAPTER 12 Consumption 290 CHAPTER 13 Investment 320 CHAPTER 14 Business Cycles 346 CHAPTER 15 Monetary Policy 377 CHAPTER 16 Stabilization Policy 408 ASSET MARKETS AND THE FINANCIAL SECTOR CHAPTER 17 Equity Markets 433 CHAPTER 18 The Bond Market 466 EXCHANGE RATES AND GLOBAL CAPITAL MARKETS CHAPTER 19 Exchange Rate Determination I—The Real Exchange Rate 496 CHAPTER 20 Exchange Rate Determination II—Nominal Exchange Rates and Asset Markets 526 CHAPTER 21 Currency Crises and Exchange Rate Systems 554 ftoc.qxd 10/8/04 12:50 pm Page viii ftoc.qxd 10/8/04 12:50 pm Page ix CONTENTS 00.00 Last H1 or EOC Head ix CHAPTER 1 What Is Macroeconomics? 1 OVERVIEW 1 1.1 WHAT IS MACROECONOMICS ABOUT? 1 1.2 BUT WHAT ABOUT THAT DEFINITION? 4 1.3 THE DIFFERENCE BETWEEN MACRO AND MICROECONOMICS 5 1.4 WHY SHOULD PEOPLE BE INTERESTED IN STUDYING MACROECONOMICS? 6 SUMMARY 11 CONCEPTUAL QUESTIONS 11 ANALYTICAL QUESTIONS 11 CHAPTER 2 The Language of Macroeconomics: The National Income Accounts 13 OVERVIEW 13 2.1 WHAT DO MACROECONOMISTS MEASURE? 13 2.2 HOW DO MACROECONOMISTS MEASURE OUTPUT? 14 2.3 OUTPUT AS VALUE ADDED 17 2.4 NATIONAL INCOME ACCOUNTS 18 2.5 HOW LARGE ARE MODERN ECONOMIES? 24 2.6 TOTAL OUTPUT AND TOTAL HAPPINESS 26 SUMMARY 31 CONCEPTUAL QUESTIONS 32 ANALYTICAL QUESTIONS 32 CHAPTER 3 The Wealth of Nations—The Supply Side 34 OVERVIEW 34 3.1 THE IMPORTANCE OF ECONOMIC GROWTH 34 3.2 EXPLAINING CROSS-COUNTRY INCOME DIFFERENCES 43 3.3 THE PRODUCTION FUNCTION AND FACTOR INPUTS 45 3.4 GROWTH ACCOUNTING 52 3.5 GROWTH ACCOUNTING—AN APPLICATION 54 SUMMARY 56 CONCEPTUAL QUESTIONS 57 ANALYTICAL QUESTIONS 58 CHAPTER 4 Capital Accumulation and Economic Growth 59 OVERVIEW 59 4.1 CAPITAL ACCUMULATION AND OUTPUT GROWTH 59 4.2 SAVINGS, INVESTMENT, AND INTEREST RATES 62 4.3 WHY POOR COUNTRIES CATCH UP WITH THE RICH 64 4.4 GROWING IMPORTANCE OF TOTAL FACTOR PRODUCTIVITY 67 4.5 THE END OF GROWTH THROUGH CAPITAL ACCUMULATION 68 4.6 WHY BOTHER SAVING? 71 4.7 HOW MUCH SHOULD A COUNTRY INVEST? 74 4.8 THE ASIAN MIRACLE—A CASE STUDY IN CAPITAL ACCUMULATION? 77 4.9 CHINA—A BIG TIGER 82 ftoc.qxd 10/8/04 12:50 pm Page x x Contents SUMMARY 84 CONCEPTUAL QUESTIONS 84 ANALYTICAL QUESTIONS 85 CHAPTER 5 Total Factor Productivity, Human Capital, and Technology 86 OVERVIEW 86 5.1 THE ROLE OF TOTAL FACTOR PRODUCTIVITY 86 5.2 HUMAN CAPITAL 88 5.3 TOTAL FACTOR PRODUCTIVITY 93 5.4 THE IMPORTANCE OF TECHNOLOGICAL PROGRESS 102 5.5 FOREIGN DIRECT INVESTMENT AND TECHNOLOGY TRANSFER 104 5.6 THE IMPACT OF ICT 105 SUMMARY 110 CONCEPTUAL QUESTIONS 111 ANALYTICAL QUESTIONS 112 CHAPTER 6 Endogenous Growth and Convergence 113 OVERVIEW 113 6.1 ENDOGENOUS GROWTH 113 6.2 POVERTY TRAPS 118 6.3 CONVERGENCE OR DIVERGENCE? 119 6.4 DETERMINANTS OF THE STEADY STATE 123 6.5 WHY IS AFRICA SO POOR? 126 6.6 DOES AID WORK? 132 SUMMARY 134 CONCEPTUAL QUESTIONS 135 ANALYTICAL QUESTIONS 136 CHAPTER 7 Unemployment and the Labor Market 137 OVERVIEW 137 7.1 LABOR MARKET DATA 137 7.2 A LONG-RUN MODEL OF THE LABOR MARKET 139 7.3 THE NATURAL RATE OF UNEMPLOYMENT 142 7.4 A DIAGRAMMATIC ANALYSIS 144 7.5 DETERMINANTS OF THE NATURAL RATE 145 7.6 WHAT LOWERS UNEMPLOYMENT? 151 7.7 A FLOW APPROACH TO THE NATURAL RATE OF UNEMPLOYMENT 152 7.8 LABOR MARKET REFORM 157 7.9 WIDENING INEQUALITY 159 7.10 IMMIGRATION 161 SUMMARY 162 CONCEPTUAL QUESTIONS 163 ANALYTICAL QUESTIONS 164 CHAPTER 8 International Trade 166 OVERVIEW 166 8.1 PATTERNS OF WORLD TRADE 167 8.2 COMPARATIVE ADVANTAGE—HOW COUNTRIES BENEFIT FROM TRADE 169 8.3 THE TERMS OF TRADE 174 8.4 WHAT GOODS WILL COUNTRIES TRADE IN? 176 ftoc.qxd 10/8/04 12:50 pm Page xi Contents xi 8.5 DISTRIBUTIONAL IMPACTS OF TRADE 181 8.6 COMPETITIVENESS 184 8.7 STRATEGIC TRADE THEORY 186 8.8 POLITICAL ECONOMY AND VESTED INTEREST 189 SUMMARY 190 CONCEPTUAL QUESTIONS 191 ANALYTICAL QUESTIONS 192 CHAPTER 9 Globalization 193 OVERVIEW 193 9.1 GLOBALIZATION—A LONG-TERM PERSPECTIVE 194 9.2 THE BENEFITS OF TRADE LIBERALIZATION 198 9.3 PROBLEMS OF GLOBALIZATION 206 9.4 INTERNATIONAL FINANCIAL INSTITUTIONS (IFIS) 212 SUMMARY 222 CONCEPTUAL QUESTIONS 223 CHAPTER 10 Fiscal Policy and the Role of Government 224 OVERVIEW 224 10.1 GOVERNMENT SPENDING 224 10.2 THE RATIONALE FOR GOVERNMENT’S ROLE AND THE FAILURE OF THE INVISIBLE HAND 229 10.3 TAXATION AND DISTORTIONS 232 10.4 DEFICITS AND TAXES 239 10.5 INTERGENERATIONAL REDISTRIBUTION AND FISCAL POLICY 244 10.6 LONG-RUN SUSTAINABILITY 246 10.7 THE INTERTEMPORAL BUDGET CONSTRAINT 249 10.8 OPTIMAL BUDGET DEFICITS 251 SUMMARY 253 CONCEPTUAL QUESTIONS 254 ANALYTICAL QUESTIONS 255 CHAPTER 11 Money and Prices 257 OVERVIEW 257 11.1 RISING PRICES 257 11.2 MEASURING INFLATION 261