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This chapter marks the first step toward the construction of the ISLM/ADAS model which will power macroeconomic analyses in the chapters to come. At this stage we have completed an intuitive overview of the broad links between global capital flows, fiscal, and trade imbalances, and their effects on interest rates and exchange rates.

This foundation chapter begins with definitions of key macrovariables and policy instruments essential to macroeconomic policy analysis.

This chapter introduces the role of intertemporal expectations into our analysis. Effects of current and expected inflation on long-term interest rates will be the focus of the first half of this chapter. This will be followed by a discussion of the ultimate macroeconomic meltdown—hyperinflation.

In Cambridge, England, as you walk up King’s Parade keeping that late-medieval architectural gem, King’s College Chapel, to your right, you will come to a fairly nondescript lane known as King’s Lane.

In the previous chapter we examined the possibility of a shift in the goods market equilibrium from E0 to a higher equilibrium E1, which equated to an equivalent rightward shift in the aggregate demand (AD) curve. This chapter continues the analysis with a discussion of the specific fiscal and monetary policies by which the AD curve can be shifted to enact demand-side stabilization. This will be followed by an in-depth description of overheating, soft landings and hard landings.

By the early 1980s, the macroeconomic landscape had changed significantly for the United States and several other Western European economies. Once-successful Keynesian discretionary demand-side stabilization policies appeared to be ineffective. The output-inflation tradeoff seemed to be no longer in evidence—expansionary fiscal and monetary stimuli only yielded additional inflation with no accompanying increase in GDP growth or employment. The Phillips curve, for all intents and purposes, appeared to be dead.

In recent times, authors of macroeconomics texts have faced a series of daunting challenges. The primary challenge lies in the very nature of the subject.

At the time in which this book was first published in 1992, there was a major concern with the macro-economic implications of fiscal imbalance. As the European economies moved closer to monetary union, and Germany grappled with the fiscal pressures of unification, deficits in the United States exceeded $300 billion. In this volume the authors address this issue, using both historical case-studies and cross-national comparisons. This book will be of interest to students of economics.

MBA alumni of Rutgers University were surveyed to determine the factors that were perceived to influence their long-term retention of course material. Exploratory factor analysis was used, and a 4-factor structure was found to be most interpretable. These factors were identified as (a) traditional, (b) interactive, (c) rejuvenating, and, (d) relevant. The results suggest that teaching methods that emphasize these 4 factors—which were also found to be independent of student academic performance—could enhance long-term retention of course material as well as the overall quality of the MBA program.

While most advanced Western countries allow the free movement of overseas capital in and out of their economies, many countries, particularly in the developing world, impose restrictions. In fact, the current dominance of freely floating rates is a relatively new historical development. Significant restrictions on capital mobility have been the norm until the globalization era which began in the 1980s. We apply the BOP equilibrium for Imperfectly Mobile Capital to the ISLM-BOP and examine how the results differ from those attained under Perfectly Mobile Capital. Here we see the applicability of the Keynesian multiplier. We move on to discuss fiscal budget sustainability and the Dornbusch model, which leads us into the history and evolution of the Euro. The current state and future of the Euro are discussed here. We discuss speculative currency attacks and their related phenomena of overshooting. We ask: how are private actors able to drive markets in the fact of powerful central banks? We explore the sources and limits of a central bank’s power.

In this final chapter we apply much of what we have previously learned as we examine several contemporary policy topics. We explore the policy of foreign exchange sterilization, and its contribution to the global imbalances that have built up in the early part of this century. The US dollar-Chinese yuan saga and controversy are explored at length. We discuss the US dollar's role as the world's reserve currency, and the potential challengers to the dollar's dominance. Finally, we explore a topic that has garnered attention in recent years as central banks have taken to increasingly unorthodox experimentation: fiat currency and the gold standard.

The journey into the main “engine room” of free trade, the Ricardian trade model, begins with a very necessary overview of some essential microeconomic building blocks, starting with the production possibilities frontier (PPF). Consumer preferences as represented by indifference curves are explained in detail with examples. The autarky production and consumption points are determined by the intersection of the production possibilities frontier with the highest possible indifference curve. Application of the Ricardian trade model shows that two trading countries can both consume on a higher indifference curve than was possible without trade. Through intra-industry trade, even countries with the same factor endowments and tastes can benefit from open trade.

World exports in 2010 included approximately US $14.9 trillion in merchandise and $3.7 trillion in services, meaning that of the world’s US $63 trillion of output, approximately 24 % involved goods and 6 % involved services traded across borders.

Finally we strip away David Ricardo’s restrictive assumptions one by one to find out: does Ricardian theory hold up even without these assumptions, in the real world? We explore the Production Life Cycle hypothesis, where countries move up the value chain, initially moving from agriculture into simple manufactures as they open up to trade, and progress through to higher and higher levels of production over time. We see how intra-industry trade, which accounts for a significant portion of the world’s trade overall, fits nicely within the Ricardian model. We present the Boeing 787 Dreamliner as a case study in intra-industry trade.

In Chapter 6 we leave the clean world of free trade and dive into trade barriers in their many incarnations, including tariffs, quotas, hassle-factors, and export subsidies. We see how tariffs harm overall welfare in both the importing and exporting countries. As bad as tariffs are, we see that quotas are even worse. Strategic trade - the protection of infant industries and champion industries - is explored at some length. Any distortive policy implemented by Country A is certain to face retaliation by Country B in the form of dumping claims and countervailing duties (CVDs). We see how these exacerbate the already bad effects of the initial barriers imposed by Country A. Finally, we take on two huge challenges to the notion of the beneficial nature of free trade: the Immiserization hypothesis, and Paul Samuelson's attack on free trade.

For centuries prior to the late eighteenth century, trade was driven by the concept of mercantilism, whereby countries gain specie (precious metals) through exports, and essentially lose by importing, and a net positive balance of trade was sought by all. Adam Smith introduced the notion of absolute advantage, whereby countries could gain by specializing in the goods they produced less expensively than the rest of the world and trading openly. David Ricardo’s concept of comparative advantage took this idea one step further: countries needn’t be the cheapest producer, only the most efficient with respect to the opportunity cost to produce their goods. Ricardo showed that between two trading countries, each will always by mathematical identity have a comparative advantage in something. Ricardo’s restricting assumptions are detailed; these will be relaxed in later chapters.

The Lucas (1973) ‘islands’ economy helped explain the procyclicality of prices and the deterioration in output-inflation tradeoffs of economies with increasing degrees of monetary ‘noise’. This model is experimentally tested by simulating an islands economy involving ‘producers’ with imperfect information, who attempt to signal-extract the real component of their observed change in prices. The results indicate that prices are procyclical and that the perceived output-inflation tradeoff worsens with increases in attempted menetary stabilization: However, it is found-that -in economies characterized by monetary indiscipline, the perceived output-inflation tradeoff becomes unresponsive to ‘reforms’ that offer lower monetary variance.

The magnitude and effects of the inflation that ravaged the Southern Confederacy have been well documented. However, there has never been any formal statistical analysis of the inflationary consequences of its monetary and fiscal policies. This paper utilizes data from the original Treasury reports to investigate the implications of war-induced fiscal expansion for debt and note issues, and for the inflation rate. The former are found to be influenced primarily by the state of the Confederate budget, while the inflation rate appears to be driven by a "confidence" index tied to developments on the military front.

After analyzing monetary policy in both Keynesian and rational expectations paradigms, and across emerging and developed economies, the time has finally come to explore the exact mechanism by which central banks enact monetary growth.

In recent times, authors of macroeconomics texts have faced a series of daunting challenges. The primary challenge lies in the very nature of the subject. Monetary and fiscal policies influence wages, employment, inflation, output, interest rates, and exchange rates and affect virtually all individuals in emerging as well as in developed economies. The applicability and pervasiveness of macroeconomics have never been in doubt. In fact, it is these very aspects that pose the major challenges to authors of texts pertaining to the analysis of monetary and fiscal policies.

In the previous chapter, we examined the possibility of a shift in the goods market equilibrium from E0 to a higher equilibrium E1, which equated to an equivalent rightward shift in the AD curve. This chapter continues the analysis with a discussion of the specific fiscal and monetary policies by which the aggregate demand (AD) curve can be shifted to enact demand-side stabilization. This will be followed by an in-depth description of overheating, soft-landings, and hard-landings.

The preceding chapters have included definitions and analyses of discrete components and aspects of the macroeconomy. We discussed the goods market and the multiplier effect in some detail, before exploring overheating and soft and hard landings using AD–AS analysis. The previous chapter included a fairly detailed study of calamitous hyperinflations, and ended with a discussion of the intertemporal and expectational influences underlying long-term interest rates.

In this chapter, changes in the rate of inflation are finally incorporated into the ISLM-ADAS analysis. This raises the overall level of sophistication of our analysis from Chapter 7 by incorporating a “real world” aggregate supply curve into the ISLM analysis. The stage is also set for an explanation of paradigm shifts between Keynesian and supply-sider models.