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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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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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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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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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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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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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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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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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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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Shifting theADcurve

An increase in

the money supply

shifts theADcurve to the right.

Y

P

AD1

AD2


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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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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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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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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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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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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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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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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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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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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 sharp oil price increases are supply shocksbecause they significantly impact production

costs and prices.


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1P

SRAS1

Y

P

AD

LRAS

YY2

CASE STUDY:


The oil price shockshifts SRASup,

causing output and

employment to fall.

A

B

In absence of

further price

shocks, prices will

fall over time andeconomy moves

back toward full

employment.

2P SRAS2

A


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CASE STUDY:


Predicted effects

of the oil shock:

inflation

output unemployment

and then a

gradual recovery. 0%

10%

20%

30%

40%

50%

60%

70%

1973 1974 1975 1976 1977

4%

6%

8%

10%

12%

Change in oil prices (left scale)

Inflation rate-CPI (right scale)

Unemployment rate (right scale)


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CASE STUDY:


Late 1970s:

As economy

was recovering,

oil prices shot upagain, causing

another huge

supply shock!!!0%

10%

20%

30%

40%

50%

60%

1977 1978 1979 1980 1981

4%

6%

8%

10%

12%

14%





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CASE STUDY:


1980s:

A favorable

supply shock--

a significant fall

in oil prices.

As the model

predicts,

inflation and

unemployment

fell:

-50%

-40%

-30%

-20%-10%

0%

10%

20%

30%

40%

1982 1983 1984 1985 1986 1987

0%

2%

4%

6%

8%

10%





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Stabilization policy

def: policy actions aimed at reducing the

severity of short-run economic fluctuations.

Example: Using monetary policy to combat the

effects of adverse supply shocks:


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Stabilizing output with

monetary policy

1P

SRAS1

Y

P

AD1

B

A

Y2

LRAS

Y

The adverse

supply shock

moves the

economy to

point B.

2P SRAS2


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Chapter Summary

1. Long run: prices are flexible, output and employment

are always at their natural rates, and the classical

theory applies.

Short run: prices are sticky, shocks can push outputand employment away from their natural rates.

2.Aggregate demand and supply:

a framework to analyze economic fluctuations

CHAPTER 9 Introduction to Economic Fluctuations slide 37


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Chapter Summary

3. The aggregate demand curve slopes downward.

4. The long-run aggregate supply curve is vertical,

because output depends on technology and factor

supplies, but not prices.

5. The short-run aggregate supply curve is horizontal,

because prices are sticky at predetermined levels.

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Chapter Summary

6. Shocks to aggregate demand and supply cause

fluctuations in GDP and employment in the short run.

7. The Fed can attempt to stabilize the economy with

monetary policy.

CHAPTER 9 I t d ti t E i Fl t ti lid 39