macro
CHAPTER NINE
Introduction to
Economic Fluctuations
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2003 Worth Publishers, all rights reserved
Chapter objectives
 difference between short run & long run
 introduction to aggregate demand
 aggregate supply in the short run & long
run
 see how model of aggregate supply and
demand can be used to analyze short-run
and long-run effects of “shocks”
CHAPTER 9
Introduction to Economic Fluctuations
slide 1
Real GDP Growth in the United States
Percent change from
4 quarters earlier
10
Average growth
rate = 3.3%
8
6
4
2
0
-2
-4
1960
1965
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1970
1975
1980
1985
1990
1995
Introduction to Economic Fluctuations
2000
slide 2
Time horizons
 Long run:
Prices are flexible, respond to changes in
supply or demand
 Short run:
many prices are “sticky” at some
predetermined level
The economy behaves much
differently when prices are sticky.
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Introduction to Economic Fluctuations
slide 3
In Classical Macroeconomic Theory,
(what we studied in chapters 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.
 Complete price flexibility is a crucial
assumption,
so classical theory applies in the long run.
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Introduction to Economic Fluctuations
slide 4
When prices are sticky
…output and employment also depend on
demand for goods & services,
which is affected by
 fiscal policy (G and T )
 monetary policy (M )
 other factors, like exogenous changes
in C or I.
CHAPTER 9
Introduction to Economic Fluctuations
slide 5
The model of
aggregate demand and supply
 the paradigm that most mainstream
economists & 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
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Introduction to Economic Fluctuations
slide 6
Aggregate demand
 The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
 For this chapter’s intro to the AD/AS model,
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 7
The Quantity Equation as Agg. Demand
 From Chapter 4, recall the quantity equation
MV = PY
 For given values of M and V, these
equations imply an inverse relationship
between P and Y:
CHAPTER 9
Introduction to Economic Fluctuations
slide 8
The downward-sloping AD curve
An increase in the
price level causes
a fall in real
money balances
(M/P ),
causing a
decrease in the
demand for goods
& services.
P
AD
Y
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Introduction to Economic Fluctuations
slide 9
Shifting the AD curve
P
An increase in
the money
supply shifts
the AD curve
to the right.
AD2
AD1
Y
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Introduction to Economic Fluctuations
slide 10
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 )
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.
CHAPTER 9
Introduction to Economic Fluctuations
slide 11
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 )
 Full-employment output does not depend
on the price level,
so the long run aggregate supply (LRAS)
curve is vertical:
CHAPTER 9
Introduction to Economic Fluctuations
slide 12
The long-run aggregate supply curve
P
LRAS
The LRAS curve
is vertical at the
full-employment
level of output.
Y
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Introduction to Economic Fluctuations
Y
slide 13
Long-run effects of an increase in M
P
LRAS
P2
In the long run,
this increases
the price level…
An increase
in M shifts
the AD curve
to the right.
P1
AD2
AD1
…but leaves
output the same.
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Y
Introduction to Economic Fluctuations
Y
slide 14
Aggregate Supply in the Short Run
 In the real world, many prices are sticky in
the short run.
 For now (and throughout Chapters 9-12),
we assume that all prices are stuck at a
predetermined level in the short run…
 …and that 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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Introduction to Economic Fluctuations
slide 15
The short run aggregate supply curve
P
The SRAS curve
is horizontal:
The price level
is fixed at a
predetermined
level, and firms
sell as much as
buyers demand.
CHAPTER 9
P
Introduction to Economic Fluctuations
SRAS
Y
slide 16
Short-run effects of an increase in M
P
In the short run
when prices are
sticky,…
…an increase
in aggregate
demand…
SRAS
AD2
AD1
P
…causes output
to rise.
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Y1
Y2
Introduction to Economic Fluctuations
Y
slide 17
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
then over time,
the price level will
Y
 Y
rise
Y
 Y
fall
Y
 Y
remain constant
This adjustment of prices is what moves
the economy to its long-run equilibrium.
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Introduction to Economic Fluctuations
slide 18
The SR & LR effects of M > 0
A = initial
equilibrium
B = new shortrun eq’m
after Fed
increases M
C = long-run
equilibrium
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P
LRAS
C
P2
P
B
A
Y
Y2
Introduction to Economic Fluctuations
SRAS
AD2
AD1
Y
slide 19
How shocking!!!
 shocks: exogenous changes in aggregate
supply or demand
 Shocks temporarily push the economy away
from full-employment.
 An example of a demand shock:
exogenous decrease in velocity
 If the money supply is held constant, then a
decrease in V means people will be using their
money in fewer transactions, causing a
decrease in demand for goods and services:
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Introduction to Economic Fluctuations
slide 20
The effects of a negative demand shock
The shock shifts
AD left, causing
output and
employment to fall
in the short run
Over time, prices
fall and the
economy moves
down its demand
curve toward fullemployment.
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P
P
LRAS
B
P2
A
SRAS
C
AD1
AD2
Y2
Y
Introduction to Economic Fluctuations
Y
slide 21
Supply 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
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.)
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Introduction to Economic Fluctuations
slide 22
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
shocks because they significantly impact
production costs and prices.
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Introduction to Economic Fluctuations
slide 23
CASE STUDY:
The 1970s oil shocks
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
P
P2
LRAS
B
SRAS2
A
P1
SRAS1
AD
Y2
Y
Introduction to Economic Fluctuations
Y
slide 24
CASE STUDY:
The 1970s oil shocks
70%
12%
Predicted effects of
the oil price shock:
• inflation 
• output 
• unemployment 
60%
…and then a
gradual recovery.
10%
50%
10%
40%
8%
30%
20%
6%
0%
1973
4%
1974
1975
1976
1977
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
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Introduction to Economic Fluctuations
slide 25
CASE STUDY:
The 1970s oil shocks
60%
Late 1970s:
As economy
was recovering,
oil prices shot up
again, causing
another huge
supply shock!!!
14%
50%
12%
40%
10%
30%
8%
20%
6%
10%
0%
1977
1978
1979
1980
4%
1981
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
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Introduction to Economic Fluctuations
slide 26
CASE STUDY:
The 1980s oil shocks
40%
1980s:
A favorable
supply shock-a significant fall
in oil prices.
As the model
would predict,
inflation and
unemployment
fell:
10%
30%
8%
20%
10%
6%
0%
-10%
4%
-20%
-30%
2%
-40%
-50%
1982
1983
1984
1985
1986
0%
1987
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
CHAPTER 9
Introduction to Economic Fluctuations
slide 27
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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Introduction to Economic Fluctuations
slide 28
Stabilizing output with
monetary policy
The adverse
supply shock
moves the
economy to
point B.
P
P2
LRAS
B
SRAS2
A
P1
SRAS1
AD1
Y2
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Y
Introduction to Economic Fluctuations
Y
slide 29
Stabilizing output with
monetary policy
P
But the Fed
accommodates
the shock by
raising agg.
demand.
P2
results:
P is permanently
higher, but Y
remains at its fullemployment level.
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LRAS
B
SRAS2
C
A
P1
AD1
Y2
Y
Introduction to Economic Fluctuations
AD2
Y
slide 30
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 output and employment away from
their natural rates.
2. Aggregate demand and supply:
a framework to analyze economic
fluctuations
CHAPTER 9
Introduction to Economic Fluctuations
slide 31
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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Introduction to Economic Fluctuations
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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.
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Introduction to Economic Fluctuations
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CHAPTER 9
Introduction to Economic Fluctuations
slide 34