9

CHAPTE
R

Introduction to Economic
Fluctuations

MACROECONOMICS SIXTH EDITION

N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2008 Worth Publishers, all rights reserved
 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 and
aggregate supply can be used to analyze the
short-run and long-run effects of “shocks.”

CHAPTER 9 Introduction to Economic Fluctuations slide 2

 Facts about the business cycle

 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
during expansions.
 Okun’s Law: the negative relationship between
GDP and unemployment.
CHAPTER 9 Introduction to Economic Fluctuations slide 3
 Growth rates of real GDP, consumption
Percent 10
change Real GDP
from 4 8 growth rate
quarters Consumption
earlier 6 growth rate

Average 4
growth
rate 2

-2

-4
1970 1975 1980 1985 1990 1995 2000 2005
Growth rates of real GDP, consumption, investment
Percent 40
change Investment
from 4 30 growth rate
quarters
earlier 20
Real GDP
10 growth rate

0
Consumption
-10 growth rate

-20

-30
1970 1975 1980 1985 1990 1995 2000 2005
 Unemployment
Percent 12
of labor
force
10

0
1970 1975 1980 1985 1990 1995 2000 2005
 Okun’s Law

Percentage 10 ∆Y
change in 1951 1966 = 3.5 − 2 ∆u
real GDP 8
Y
1984
6
2003
4

2 1987

0 1975
2001
-2
1991 1982
-4
-3 -2 -1 0 1 2 3 4
Change in unemployment rate
 Index of Leading Economic
Indicators
 Published monthly by the Conference Board.
 Aims to forecast changes in economic activity
6-9 months into the future.
 Used in planning by businesses and govt,
despite not being a perfect predictor.

CHAPTER 9 Introduction to Economic Fluctuations slide 8

 Components of the LEI index
 Average workweek in manufacturing
 Initial weekly claims for unemployment insurance
 New orders for consumer goods and materials
 New orders, nondefense 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
CHAPTER 9 Introduction to Economic Fluctuations slide 9
 Index of Leading Economic Indicators
160

140

120
1996 = 100

100

80

60

40

20

Source:
0
Conference 1970 1975 1980 1985 1990 1995 2000 2005
Board
 Time horizons in
macroeconomics
 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.

CHAPTER 9 Introduction to Economic Fluctuations slide 11

 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.

CHAPTER 9 Introduction to Economic Fluctuations slide 12

 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.

CHAPTER 9 Introduction to Economic Fluctuations slide 13

 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 economy’s behavior is different
in the short run and long run

CHAPTER 9 Introduction to Economic Fluctuations slide 14

 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 15

 The Quantity Equation as
Aggregate Demand

 From Chapter 4, recall the quantity equation

MV = PY
 For given values of M and V,
this equation implies an inverse relationship
between P and Y :

CHAPTER 9 Introduction to Economic Fluctuations slide 16

 The downward-sloping AD curve

P
An
An increase
increase in in the
the
price
price level
level causes
causes
aa fall
fall in
in real
real money
money
balances
balances (M/P (M/P),),
causing
causing aa
decrease
decrease inin the
the
demand
demand for
for goods
goods AD
&
& services.
services.
Y

CHAPTER 9 Introduction to Economic Fluctuations slide 17

 Shifting the AD curve

An
An increase
increase in in
the
the money
money supply
supply
shifts
shifts the
the AD
AD
curve
curve toto the
the right.
right.
AD
AD 2

1
Y

CHAPTER 9 Introduction to Economic Fluctuations slide 18

 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 (not zero).
CHAPTER 9 Introduction to Economic Fluctuations slide 19
 The long-run aggregate supply
curve
P LRAS
Y does
does not
not
depend
depend on on P,
P,
so
so LRAS
LRAS is is
vertical.
vertical.

Y
Y
= F (K , L)
CHAPTER 9 Introduction to Economic Fluctuations slide 20
 Long-run effects of an increase
in M
P LRAS
An increase
in M shifts AD
to the right.

In the long run, P2

this raises the
price level… P1 AD
AD 2

1
…but leaves Y
Y
output the same.

CHAPTER 9 Introduction to Economic Fluctuations slide 21

 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:

CHAPTER 9 Introduction to Economic Fluctuations slide 22

 The short-run aggregate supply
curve
P
The
The SRAS
SRAS
curve
curve is
is
horizontal:
horizontal:
The
The price
price level
level
is
is fixed
fixed at
at aa SRAS
predetermined
predetermined P
level,
level, and
and firms
firms
sell
sell asas much
much as as
buyers
buyers demand.
demand. Y

CHAPTER 9 Introduction to Economic Fluctuations slide 23

 Short-run effects of an increase
in M
P
In the short run …an increase
when prices are in aggregate
sticky,… demand…

SRAS
P
AD
AD2
1
Y
…causes output Y1 Y2
to rise.
CHAPTER 9 Introduction to Economic Fluctuations slide 24
 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 then over time,
equilibrium, if P will…
Y > Y rise
Y < Y fall

Y = Y remain constant

The adjustment of prices is what moves the

economy to its long-run equilibrium.
CHAPTER 9 Introduction to Economic Fluctuations slide 25
 The SR & LR effects of ∆ M > 0

A = initial P LRAS
equilibrium

B = new short-
P2 C
run eq’m
after Fed B SRAS
increases M P
A AD
AD2
C = long-run 1
equilibrium Y
Y Y2

CHAPTER 9 Introduction to Economic Fluctuations slide 26

 How shocking!!!

 shocks: exogenous changes in agg. supply or

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.

CHAPTER 9 Introduction to Economic Fluctuations slide 27

 The effects of a negative demand
shock
AD
AD shifts
shifts left,
left, P LRAS
depressing
depressing output
output
and
and employment
employment
in
in the
the short
short run.
run.
B A SRAS
Over
Over time,
time, P
prices
prices fall
fall and
and
P2 C AD
the
the economy
economy
moves
moves down
down its
its AD1
demand
demand curve
curve 2
Y
toward
toward full-
full- Y2 Y
employment.
employment.
CHAPTER 9 Introduction to Economic Fluctuations slide 28
 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.
CHAPTER 9 Introduction to Economic Fluctuations slide 29
 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.
CHAPTER 9 Introduction to Economic Fluctuations slide 30
 CASE STUDY:
The 1970s oil shocks
The
The oil
oil price
price shock
shock P LRAS
shifts
shifts SRAS
SRAS up, up,
causing
causing output
output and
and
employment
employment to to fall.
fall.
B SRAS2
P2
In
In absence
absence ofof
A SRAS1
further
further price
price P1
shocks,
shocks, prices
prices will
will AD
fall
fall over
over time
time and
and
economy
economy movesmoves Y
back
back toward
toward full
full Y2 Y
employment.
employment.
CHAPTER 9 Introduction to Economic Fluctuations slide 31
 CASE STUDY:
The 1970s oil shocks
70%
Predicted effects 60%
of the oil shock:
50%
• inflation ↑
40%
• output ↓
• unemployment ↑ 30%

20%
…and then a
gradual recovery. 10%
0%
1973 1974 1975 1976 19

Change in oil prices (left scale)

CHAPTER 9 Inflation rate-CPI (right scale)
Introduction to Economic Fluctuations slide 32
 CASE STUDY:
The 1970s oil shocks
60%
Late 1970s:
50%
As economy
was recovering, 40%
oil prices shot up
30%
again, causing
another huge 20%
supply shock!!!
10%

0%
1977 1978 1979 1980 19

Change in oil prices (left scale)

CHAPTER 9 Introduction to Economic Inflation
Fluctuations
rate-CPI (right scale)
slide 33
 CASE STUDY:
The 1980s oil shocks
40%
1980s: 30%
A favorable 20%
supply shock-- 10%
a significant fall 0%
in oil prices. -10%
As the model -20%
predicts, -30%
inflation and -40%
unemployment
-50%
fell:
1982 1983 1984 1985 1986 198

Change in oil prices (left scale)

CHAPTER 9 Introduction to EconomicInflation
Fluctuations slide 34
rate-CPI (right scale)
 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:

CHAPTER 9 Introduction to Economic Fluctuations slide 35

 Stabilizing output with
monetary policy
P LRAS

The
The adverse
adverse
supply
supply shock
shock B SRAS2
moves
moves the
the P2
economy
economy toto A SRAS1
point P1
point B.
B.
AD
1

Y
Y2 Y

CHAPTER 9 Introduction to Economic Fluctuations slide 36

 Stabilizing output with
monetary policy
But P LRAS
But the
the Fed
Fed
accommodates
accommodates
the
the shock
shock by
by
raising
raising agg.
agg. B C SRAS2
demand.
demand. P2
A
results: P1 AD
results:
P
P is
is permanently
permanently AD 2

higher,
higher, but
but YY 1

remains
remains atat its
its full-
full- Y
Y2 Y
employment
employment level.level.

CHAPTER 9 Introduction to Economic Fluctuations slide 37

 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 38

 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.

CHAPTER 9 Introduction to Economic Fluctuations slide 39

 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 Introduction to Economic Fluctuations slide 40