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    slide 0CHAPTER 9 Introduction to Economic Fluctuations

    MacroeconomicsSixth Edition

    Chapter 9:Introduction to Economic Fluctuations

    Econ 4020/Chatterjee

    N. Gregory Mankiw

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    slide 1CHAPTER 9 Introduction to Economic Fluctuations

    In this chapter, you will learn

    facts about the business cycle

    how the short run differs from the long run

    an introduction to aggregate demand

    an introduction to aggregate supply in the short

    run and long run

    how the model of aggregate demand andaggregate supply can be used to analyze the

    short-run and long-run effects of shocks.

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    Growth rates of real GDP, consumption

    -4

    -2

    0

    2

    4

    6

    8

    10

    1970 1975 1980 1985 1990 1995 2000 2005

    Real GDP

    growth rate

    Averagegrowthrate

    Consumptiongrowth rate

    Percent

    change

    from 4quarters

    earlier

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    Growth rates of real GDP, consumption, investment

    -30

    -20

    -10

    0

    10

    20

    30

    40

    1970 1975 1980 1985 1990 1995 2000 2005

    Percent

    change

    from 4quarters

    earlier

    Investmentgrowth rate

    Real GDPgrowth rate

    Consumptiongrowth rate

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    Unemployment

    0

    2

    4

    6

    8

    10

    12

    1970 1975 1980 1985 1990 1995 2000 2005

    Percent

    of labor

    force

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    Okuns Law

    Percentage

    change inreal GDP

    Change in unemployment rate

    -4

    -2

    0

    2

    4

    6

    8

    10

    -3 -2 -1 0 1 2 3 4

    1975

    198219912001

    1984

    1951 1966

    2003

    1987

    3.5 2 Y

    uY

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    slide 8CHAPTER 9 Introduction to Economic Fluctuations

    Components of the LEI index

    Average workweek in manufacturing

    Initial weekly claims for unemployment insurance

    New orders for consumer goods and materials

    New orders, non-defense capital goods Vendor performance

    New building permits issued

    Index of stock prices

    M2

    Yield spread (10-year minus 3-month) on Treasuries

    Index of consumer expectations

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    Index of Leading Economic Indicators

    0

    20

    40

    60

    80

    100

    120

    140

    160

    1970 1975 1980 1985 1990 1995 2000 2005

    1996=

    100

    Source:

    ConferenceBoard

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    slide 11CHAPTER 9 Introduction to Economic Fluctuations

    Recap of classical macro theory(Chaps. 3-8)

    Output is determined by the supply side:

    supplies of capital, labor

    technology.

    Changes in demand for goods & services

    (C, I, G) only affect prices, not quantities.

    Assumes complete price flexibility.

    Applies to the long run.

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    slide 12CHAPTER 9 Introduction to Economic Fluctuations

    When prices are sticky

    output and employment also depend on

    demand, which is affected by

    fiscal policy (G and T)

    monetary policy (M)

    other factors, like exogenous changes in

    C or I.

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    slide 13CHAPTER 9 Introduction to Economic Fluctuations

    The model of

    aggregate demand and supply

    the paradigm most mainstream economists

    and policymakers use to think about economic

    fluctuations and policies to stabilize the economy

    shows how the price level and aggregate output

    are determined

    shows how the economys behavior is different

    in the short run and long run

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    slide 14CHAPTER 9 Introduction to Economic Fluctuations

    Aggregate demand

    The aggregate demand curve shows the

    relationship between the price level and the

    quantity of output demanded.

    For this chapters intro to theAD/ASmodel,

    we use a simple theory of aggregate demand

    based on the quantity theory of money.

    Chapters 10-12 develop the theory of aggregatedemand in more detail.

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    slide 15CHAPTER 9 Introduction to Economic Fluctuations

    The Quantity Equation as

    Aggregate Demand

    From Chapter 4, recall the quantity equation

    M V = P Y

    For given values of M and V,this equation implies an inverse relationship

    between P and Y:

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    slide 16CHAPTER 9 Introduction to Economic Fluctuations

    The downward-slopingADcurve

    An increase in the

    price level causes

    a fall in real money

    balances (M/P),causing a

    decrease in the

    demand for goods

    & services.Y

    P

    AD

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    slide 17CHAPTER 9 Introduction to Economic Fluctuations

    Shifting theADcurve

    An increase in

    the money supply

    shifts theADcurve to the right.

    Y

    P

    AD1

    AD2

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    slide 18CHAPTER 9 Introduction to Economic Fluctuations

    Aggregate supply in the long run

    Recall from Chapter 3:In the long run, output is determined by

    factor supplies and technology

    , ( )Y F K L

    is the full-employmentor naturallevel of

    output, the level of output at which the

    economys resources are fully employed.

    Y

    Full employment means that

    unemployment equals its natural rate (not zero).

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    slide 19CHAPTER 9 Introduction to Economic Fluctuations

    The long-run aggregate supply

    curve

    Y

    P LRAS

    does not

    depend on P,

    so LRASisvertical.

    Y

    ( ) ,

    Y

    F K L

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    slide 20CHAPTER 9 Introduction to Economic Fluctuations

    Long-run effects of an increase in M

    Y

    P

    AD1

    LRAS

    Y

    An increase

    in M shifts

    AD to the

    right.

    P1

    P2In the long run,

    this raises the

    price level

    but leaves

    output the same.

    AD2

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    slide 21CHAPTER 9 Introduction to Economic Fluctuations

    Aggregate supply in the short run

    Many prices are sticky in the short run.

    For now (and through Chap. 12), we assume

    all prices are stuck at a predetermined level in

    the short run.

    firms are willing to sell as much at that price

    level as their customers are willing to buy.

    Therefore, the short-run aggregate supply(SRAS) curve is horizontal:

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    slide 22CHAPTER 9 Introduction to Economic Fluctuations

    The short-run aggregate supply curve

    Y

    P

    P SRAS

    The SRAS

    curve is

    horizontal:

    The price levelis fixed at a

    predetermined

    level, and firms

    sell as much asbuyers demand.

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    slide 23CHAPTER 9 Introduction to Economic Fluctuations

    Short-run effects of an increase in M

    Y

    P

    AD1

    In the short run

    when prices are

    sticky,

    causes

    output to rise.

    P SRAS

    Y2Y1

    AD2

    an increase

    in aggregate

    demand

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    slide 25CHAPTER 9 Introduction to Economic Fluctuations

    The SR & LR effects of M>0

    Y

    P

    AD1

    LRAS

    Y

    P SRAS

    P2

    Y2

    A = initialequilibrium

    A

    B

    C

    B = new short-

    run eqm

    after Fed

    increases M

    C = long-run

    equilibrium

    AD2

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    slide 27CHAPTER 9 Introduction to Economic Fluctuations

    P SRAS

    LRAS

    AD2

    The effects of a negative demand shock

    Y

    P

    AD1

    Y

    P2

    Y2

    ADshifts left,depressing output

    and employment

    in the short run.

    A

    B

    C

    Over time,

    prices fall and

    the economy

    moves down itsdemand curve

    toward full-

    employment.

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    slide 28CHAPTER 9 Introduction to Economic Fluctuations

    Supply shocks

    A supply shockalters production costs, affects theprices that firms charge. (also called price shocks)

    Examples of adversesupply shocks:

    Bad weather reduces crop yields, pushing upfood prices.

    Workers unionize, negotiate wage increases.

    New environmental regulations require firms to

    reduce emissions. Firms charge higher prices tohelp cover the costs of compliance.

    Favorablesupply shocks lower costs and prices.

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    slide 29CHAPTER 9 Introduction to Economic Fluctuations

    CASE STUDY:

    The 1970s oil shocks

    Early 1970s: OPEC coordinates a reduction in

    the supply of oil.

    Oil prices rose

    11% in 1973

    68% in 1974

    16% in 1975

    Such sha