9

CHAPTER

Introduction to Economic
Fluctuations

MACROECONOMICS SIXTH EDITION

N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 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 1

 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 2

 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
 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 7

 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 8

 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 9

 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 10

 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 11

 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 12

 The downward-sloping AD curve

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

CHAPTER 9 Introduction to Economic Fluctuations slide 13

 Shifting the AD curve

P
An increase in
the money supply
shifts the AD
curve to the right.

AD2
AD1
Y

CHAPTER 9 Introduction to Economic Fluctuations slide 14

 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 15
 The long-run aggregate supply
curve
P LRAS
Y does not
depend on P,
so LRAS is
vertical.

Y
Y
 F (K , L )
CHAPTER 9 Introduction to Economic Fluctuations slide 16
 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 AD2
AD1

…but leaves Y
output the same.
Y

CHAPTER 9 Introduction to Economic Fluctuations slide 17

 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 18

 The short-run aggregate supply curve

P
The SRAS
curve is
horizontal:
The price level
is fixed at a
SRAS
predetermined P
level, and firms
sell as much as
buyers demand. Y

CHAPTER 9 Introduction to Economic Fluctuations slide 19

 Short-run effects of an increase in M

In the short run P

…an increase
when prices are
in aggregate
sticky,…
demand…

SRAS
P
AD2
AD1
Y
…causes Y1 Y2
output to rise.
CHAPTER 9 Introduction to Economic Fluctuations slide 20
 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 21
 The SR & LR effects of M > 0

A = initial P LRAS
equilibrium

B = new short-
run eq’m P2 C
after Fed B SRAS
increases M P A AD2
AD1
C = long-run
equilibrium Y
Y Y2

CHAPTER 9 Introduction to Economic Fluctuations slide 22

 The effects of a negative demand shock

AD shifts left, P LRAS

depressing output
and employment
in the short run.
B A SRAS
Over time, P
prices fall and
P2 C AD1
the economy
moves down its AD2
demand curve Y
toward full- Y2 Y
employment.
CHAPTER 9 Introduction to Economic Fluctuations slide 23
 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 24
 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 25
 CASE STUDY:
The 1970s oil shocks
The oil price shock P LRAS
shifts SRAS up,
causing output and
employment to fall.
B SRAS2
P2
In absence of
A SRAS1
further price P1
shocks, prices will AD
fall over time and
economy moves
Y
back toward full Y2 Y
employment.
CHAPTER 9 Introduction to Economic Fluctuations slide 26
 CASE STUDY:
The 1970s oil shocks
70%
12%
Predicted effects 60%
of the oil shock: 50% 10%
• inflation  40%
• output  30%
8%

• unemployment  20%
6%
…and then a 10%
gradual recovery. 0% 4%
1973 1974 1975 1976 1977

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
Unemployment rate (right scale)
CHAPTER 9 Introduction to Economic Fluctuations slide 27
 CASE STUDY:
The 1970s oil shocks
60% 14%

Late 1970s: 50%

12%
As economy 40%
was recovering, 10%
30%
oil prices shot up
8%
again, causing 20%
another huge 6%
10%
supply shock!!!
0% 4%
1977 1978 1979 1980 1981

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
Unemployment rate (right scale)
CHAPTER 9 Introduction to Economic Fluctuations slide 28
 CASE STUDY:
The 1980s oil shocks
40% 10%
1980s: 30%
20% 8%
A favorable
10%
supply shock-- 6%
0%
a significant fall
-10%
in oil prices. 4%
-20%
As the model -30% 2%
predicts, -40%
inflation and -50% 0%
unemployment 1982 1983 1984 1985 1986 1987
fell: Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
CHAPTER 9 Introduction to Economic Fluctuations slide 29
 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 30

 Stabilizing output with
monetary policy
P LRAS

The adverse
supply shock
B SRAS2
moves the P2
economy to A SRAS1
point B. P1
AD1

Y
Y2 Y

CHAPTER 9 Introduction to Economic Fluctuations slide 31

 Stabilizing output with
monetary policy
But the Fed P LRAS
accommodates
the shock by
raising agg.
B C SRAS2
demand. P2
A
results: P1 AD2
P is permanently AD1
higher, but Y
remains at its full- Y
Y2 Y
employment level.

CHAPTER 9 Introduction to Economic Fluctuations slide 32

 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 33

 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 34

 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 35