CHAPTER
In this chapter, you will learn…
9
 facts about the business cycle
Introduction to Economic
Fluctuations
 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
MACROECONOMICS
SIXTH EDITION
N. GREGORY MANKIW
 how the model of aggregate demand and
aggregate supply can be used to analyze the
short-run and long-run effects of “shocks.”
PowerPoint® Slides by Ron Cronovich
CHAPTER 9
© 2007 Worth Publishers, all rights reserved
 GDP growth averages 3–3.5 percent per year over
the long run with large fluctuations in the short run.
 Consumption and investment fluctuate with GDP,
but consumption tends to be less volatile and
investment more volatile than GDP.
 Unemployment rises during recessions and falls
 Okun’s Law: the negative relationship between
GDP and unemployment.
Introduction to Economic Fluctuations
Percent 10
change
from 4 8
quarters
earlier 6
Real GDP
growth rate
Consumption
growth rate
Average 4
growth
rate 2
0
during expansions.
slide 2
-2
-4
1970
1975
Growth rates of real GDP, consumption, investment
Percent 40
change
from 4 30
quarters
earlier 20
Real GDP
growth rate
1985
1990
1995
2000
2005
1995
2000
2005
Unemployment
8
6
0
Consumption
growth rate
-10
4
2
-20
-30
1970
1980
Percent 12
of labor
force
10
Investment
growth rate
10
slide 1
Growth rates of real GDP, consumption
Facts about the business cycle
CHAPTER 9
Introduction to Economic Fluctuations
1975
1980
1985
1990
1995
2000
2005
0
1970
1975
1980
1985
1990
1
Okun’s Law
Percentage 10
change in
real GDP 8
1951
Index of Leading Economic Indicators
!Y
= 3.5 " 2 !u
Y
1966
1984
6
6-9 months into the future.
2003
4
 Used in planning by businesses and govt,
1987
2
 Published monthly by the Conference Board.
 Aims to forecast changes in economic activity
despite not being a perfect predictor.
0
1975
2001
-2
1991
1982
-4
-3
-2
-1
0
1
2
3
4
Change in unemployment rate
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slide 7
Index of Leading Economic Indicators
Components of the LEI index
160
Average workweek in manufacturing
Initial weekly claims for unemployment insurance
140
New orders for consumer goods and materials
120
1996 = 100










Introduction to Economic Fluctuations
New orders, nondefense capital goods
Vendor performance
New building permits issued
100
80
60
Index of stock prices
40
M2
20
Yield spread (10-year minus 3-month) on Treasuries
Index of consumer expectations
CHAPTER 9
Introduction to Economic Fluctuations
slide 8
Time horizons in macroeconomics
 Long run:
 Short run:
Many prices are “sticky” at some predetermined
level.
The economy behaves much
differently when prices are sticky.
Introduction to Economic Fluctuations
0
1970
1975
1980
1985
1990
1995
2000
2005
Recap of classical macro theory
(Chaps. 3-8)
 Output is determined by the supply side:
Prices are flexible, respond to changes in supply
or demand.
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Source:
Conference
Board
slide 10
 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.
CHAPTER 9
Introduction to Economic Fluctuations
slide 11
2
The model of
aggregate demand and supply
When prices are sticky…
 the paradigm most mainstream economists
…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.
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 economy’s behavior is different
in the short run and long run
CHAPTER 9
Introduction to Economic Fluctuations
slide 12
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Introduction to Economic Fluctuations
slide 13
The Quantity Equation as
Aggregate Demand
Aggregate demand
 The aggregate demand curve shows the
 From Chapter 4, recall the quantity equation
relationship between the price level and the
quantity of output demanded.
MV = PY
 For given values of M and V,
 For this chapter’s intro to the AD/AS model,
this equation implies an inverse relationship
between P and Y :
we use a simple theory of aggregate demand
based on the quantity theory of money.
 Chapters 10-12 develop the theory of aggregate
demand in more detail.
CHAPTER 9
Introduction to Economic Fluctuations
slide 14
The downward-sloping AD curve
An increase in the
price level causes
a fall in real money
balances (M/P ),
Introduction to Economic Fluctuations
Introduction to Economic Fluctuations
slide 15
Shifting the AD curve
P
causing a
decrease in the
demand for goods
& services.
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CHAPTER 9
P
An increase in
the money supply
shifts the AD
curve to the right.
AD2
AD
AD1
Y
slide 16
Y
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Introduction to Economic Fluctuations
slide 17
3
Aggregate supply in the long run
The long-run aggregate supply
curve
 Recall from Chapter 3:
P
In the long run, output is determined by
factor supplies and technology
LRAS
Y does not
depend on P,
so LRAS is
vertical.
Y = F (K , L )
Y is the full-employment or natural level of
output, the level of output at which the
economy’s resources are fully employed.
“Full employment” means that
unemployment equals its natural rate (not zero).
CHAPTER 9
Introduction to Economic Fluctuations
slide 18
Long-run effects of an increase in M
P
In the long run,
this raises the
price level…
LRAS
P2
An increase
in M shifts
AD to the
right.
AD2
AD1
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Y
slide 20
The short-run aggregate supply curve
P
The price level
is fixed at a
predetermined
level, and firms
sell as much as
buyers demand.
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Introduction to Economic Fluctuations
slide 19
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.
P
Introduction to Economic Fluctuations
level as their customers are willing to buy.
 Therefore, the short-run aggregate supply
Y
Introduction to Economic Fluctuations
The SRAS
curve is
horizontal:
CHAPTER 9
 firms are willing to sell as much at that price
P1
…but leaves
output the same.
Y
Y
= F (K , L )
(SRAS) curve is horizontal:
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Introduction to Economic Fluctuations
slide 21
Short-run effects of an increase in M
In the short run
when prices are
sticky,…
SRAS
P
…an increase
in aggregate
demand…
SRAS
AD2
AD1
P
Y
slide 22
…causes
output to rise.
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Y1
Introduction to Economic Fluctuations
Y2
Y
slide 23
4
From the short run to the long run
Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
In the short-run
equilibrium, if
rise
Y <Y
fall
Y =Y
remain constant
B = new shortrun eq’m
after Fed
increases M
Introduction to Economic Fluctuations
slide 24
How shocking!!!
demand
 Shocks temporarily push the economy away from
full employment.
 Example: exogenous decrease in velocity
If the money supply is held constant, a decrease in
V means people will be using their money in fewer
transactions, causing a decrease in demand for
goods and services.
Introduction to Economic Fluctuations
slide 26
A
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SRAS
AD2
AD1
Y
Y2
Y
Introduction to Economic Fluctuations
slide 25
P
AD shifts left,
depressing output
and employment
in the short run.
Over time,
prices fall and
the economy
moves down its
demand curve
toward fullemployment.
CHAPTER 9
P
LRAS
A
B
C
P2
SRAS
AD1
AD2
Y2
Y
Introduction to Economic Fluctuations
Y
slide 27
The 1970s oil shocks
 A supply shock alters production costs, affects the
prices that firms charge. (also called price shocks)
 Examples of adverse supply shocks:
 Bad weather reduces crop yields, pushing up
 Early 1970s: OPEC coordinates a reduction in
the supply of oil.
 Oil prices rose
food prices.
 Workers unionize, negotiate wage increases.
 New environmental regulations require firms to
reduce emissions. Firms charge higher prices to
help cover the costs of compliance.
 Favorable supply shocks lower costs and prices.
Introduction to Economic Fluctuations
B
P
CASE STUDY:
Supply shocks
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C
P2
The effects of a negative demand shock
 shocks: exogenous changes in agg. supply or
CHAPTER 9
LRAS
C = long-run
equilibrium
The adjustment of prices is what moves the
economy to its long-run equilibrium.
CHAPTER 9
P
A = initial
equilibrium
then over time,
P will…
Y >Y
The SR & LR effects of ΔM > 0
slide 28
11% in 1973
68% in 1974
16% in 1975
 Such sharp oil price increases are supply shocks
because they significantly impact production
costs and prices.
CHAPTER 9
Introduction to Economic Fluctuations
slide 29
5
CASE STUDY:
Stabilization policy
The 1970s oil shocks
P
The oil price shock
shifts SRAS up,
causing output and
employment to fall.
In absence of
further price
shocks, prices will
fall over time and
economy moves
back toward full
employment.
CHAPTER 9
LRAS
 def: policy actions aimed at reducing the
severity of short-run economic fluctuations.
P2
B
SRAS2
A
P1
AD
Y2
Y
Y
slide 30
Stabilizing output with
monetary policy
P
P2
B
SRAS2
A
P1
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Introduction to Economic Fluctuations
slide 34
Stabilizing output with
monetary policy
LRAS
SRAS1
AD1
Y2
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effects of adverse supply shocks:
SRAS1
Introduction to Economic Fluctuations
The adverse
supply shock
moves the
economy to
point B.
 Example: Using monetary policy to combat the
Y
Introduction to Economic Fluctuations
Y
slide 35
Chapter Summary
But the Fed
accommodates
the shock by
raising agg.
demand.
P
P2
P1
results:
P is permanently
higher, but Y
remains at its fullemployment level.
CHAPTER 9
LRAS
B
C
SRAS2
A
AD1
Y2
AD2
Y
Introduction to Economic Fluctuations
3. The aggregate demand curve slopes downward.
are always at their natural rates, and the classical
theory applies.
4. The long-run aggregate supply curve is vertical,
Short run: prices are sticky, shocks can push output
and employment away from their natural rates.
because output depends on technology and factor
supplies, but not prices.
5. The short-run aggregate supply curve is horizontal,
2. Aggregate demand and supply:
because prices are sticky at predetermined levels.
a framework to analyze economic fluctuations
Introduction to Economic Fluctuations
slide 36
Chapter Summary
1. Long run: prices are flexible, output and employment
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Y
slide 37
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Introduction to Economic Fluctuations
slide 38
6
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.
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Introduction to Economic Fluctuations
slide 39
7