INTRODUCTION TO ECONOMIC

FLUCTUATIONS
CHAPTER:9
BOOK: “Macroeconomics by Mankiw”
 CHAPTERS

 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.”
1
 INTRODUCTION

 business cycle: Short-run fluctuations in output and

employment
 GDP is the largest gauge of economic conditions.
 Pakistan bureau of statistics: determiner a recession.
 A recession: two consecutive declines in real GDP.
 Investment is even more susceptible to decline.

1
 OKUN’S LAW

 In recessions, unemployment rises.

 This negative relationship between unemployment and GDP is called Okun’s

Law
Percentage Change in Real GDP = 3% - 2 the Change in the Unemployment Rate

 If the unemployment rate rises from 5 to 8 percent

Percentage Change in Real GDP = 3% - 2 (7% - 5%) = -1 %

 Okun’s law is a reminder that the forces that govern the short-run business

cycle are very different from those that shape long-run economic growth.
 TIME HORIZONS IN MACROECONOMICS
 Classical macroeconomic theory applies to the long run but not to the short

run–WHY?

 The short run and long run differ in terms of the treatment of prices.

 In the long run, prices are flexible.

 In the short run, many prices are “sticky”.

 Because prices behave differently in the short run than in the long run,

economic policies have different effects over different time horizons. Let’s
see this in action.a
 TIME HORIZONS IN MACROECONOMICS
 consider the effects of a change in monetary policy

Long Run
 According to the classical model, the money supply affects nominal variables
 classical dichotomy: the theoretical separation of real and nominal variables is called
the classical dichotomy
 monetary neutrality: the irrelevance of the money supply for the determination of
real variables.
 reduction in the money supply lowers all prices
 while output, employment, and other real variables remain the same.

Short Run
 Many prices do not respond to changes in monetary policy.
 real variables such as output and employment must do some of the adjusting instead.
 THE MODEL OF AGGREGATE SUPPLY AND
AGGREGATE DEMAND
 Output is determined by the supply side:
 supplies of capital, labor
 technology.
 Assumes complete price flexibility.
 Applies to the long run.
 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.
 AGGREGATE DEMAND

 The aggregate-demand curve shows the quantity of goods and

services that households, firms, and the government want to buy
at each price level.
 The aggregate-supply curve shows the quantity of goods and
services that firms choose to produce and sell at each price level
 The four components of GDP (Y) contribute to the aggregate
demand for goods and services.
Y = C + I + G + NX
 THE AGGREGATE DEMAND CURVE SLOPES
DOWNWARD

 Why the Aggregate-Demand Curve Is

Downward Sloping
 The Price Level and Consumption:
 The Wealth Effect

 The Price Level and Investment:

 The Interest Rate Effect

 The Price Level and Net Exports:

 The Exchange-Rate Effect
 THE AGGREGATE DEMAND CURVE SLOPES
DOWNWARD
1. The Price Level and Consumption:
 The Wealth Effect
 A lower price level raises the real value of money and makes
consumers wealthier, which encourages them to spend more.
 This increase in consumer spending means larger quantities of goods
and services demanded.
2. The Price Level and Investment:
 The Interest Rate Effect
 A lower price level reduces the interest rate and makes borrowing less
expensive, which encourages greater spending on investment goods.
 This increase in investment spending means a larger quantity of goods
and services demanded.
 THE AGGREGATE DEMAND CURVE SLOPES
DOWNWARD
3. The Price Level and Net Exports:
 The Exchange-Rate Effect
 A lower price level in the U.S. causes U.S. interest rates to fall and the
real exchange rate to depreciate, which stimulates U.S. net exports.
 The increase in net export spending means a larger quantity of goods
and services demanded.
 SHIFTING AD CURVE
 The downward slope of the
aggregate-demand curve shows that
a fall in the price level raises the
overall quantity of goods and
services demanded.
 Many other factors, however, affect
the quantity of goods and services
demanded at any given price level.
 When one of these other factors
changes, the aggregate demand
curve shifts.
 Shift arise from changes in:
 Consumption, Investment
 Government Purchases, Net Exports
 AGGREGATE SUPPLY
 Aggregate supply (AS) is the relationship between the quantity of goods

and services supplied and the price level.

 Because the firms that supply goods and services have flexible prices in

the long run but sticky prices in the short run, the aggregate supply
relationship depends on the time horizon.

 There are two different aggregate supply curves: the long-run aggregate

supply curve (LRAS) and the short-run aggregate supply curve (SRAS).
 LONG RUN AGGREGATE SUPPLY
 In the long run, output is determined by factor supplies and technology

 Y=f(K,L)

 It is at the full-employment or natural level of output

 LONG RUN AGGREGATE SUPPLY
 A reduction in the AD shift the

aggregate demand curve

downward from AD1 to AD2.
Since the AS curve is vertical in
the long run, the reduction in AD
affects the price level, but not the
level of output.

 The vertical-aggregate supply

curve satisfies the classical
dichotomy
 SHORT RUN AGGREGATE SUPPLY
 Many prices are sticky 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:
 SHORT RUN AGGREGATE SUPPLY
 A reduction in the AD the
aggregate demand curve down
ward from AD1 to AD2.

 reduction in aggregate demand

reduces the level of output

 prices do not adjust instantly
 FROM THE SHORT RUN TO THE LONG RUN
 How does the economy make the

transition from the short run to the

long run?

 Suppose as fall in aggregate

demand. Suppose that the

economy is initially in long-run
equilibrium.
 Now suppose that the Fed reduces the

money supply and the aggregate

 FROM THE SHORT RUN TO THE LONG RUN
 In the short run, prices are sticky, so the

economy moves from point A to point B.

 Output and employment fall below their

natural levels, which means the economy

is in a recession. demand curve to point C,
which is the new long-run equilibrium. In
the new

 long-run equilibrium (point C), output and

employment are back to their natural

levels, but prices are lower than in the old
long-run equilibrium (point A).
 SHOCKS IN MACRO
 Exogenous changes in aggregate supply or aggregate demand are called shocks.

 supply shock

 demand shock.

 These shocks that disrupt the economy push output and unemployment away from

their natural levels.

 Economists use stabilization policy to refer to policy seeks to dampen the business

cycle by keeping output and employment as close to their natural rate as possible.
 SHOCKS TO AGGREGATE DEMAND
 Consider an example of a demand shock: the
introduction and expanded availability of credit
cards.
 This reduce the quantity of money that people
choose to hold.
 The reduction in money demand is equivalent to
an increase in the velocity of money.
 If the money supply is held constant, the increase
in velocity causes nominal spending to rise and the
aggregate demand curve to shift outward.
 An increase in aggregate demand, moves the economy from point A to point B, where
output is above its natural level.
 As prices rise, output gradually returns to its natural level, and the economy moves from
point B to point C
 SHOCKS TO AGGREGATE SUPPLY
 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
 Workers unionize
 New environmental regulations require firms to
reduce emissions.
 Favorable supply shocks lower costs and prices.

 An adverse supply shock pushes up costs and thus prices.

 If aggregate demand is held constant, the economy moves from point A to point B,
leading to stagflation—a combination of increasing prices and falling output.
 Eventually, as prices fall, the economy returns to the natural level of output, point A
 ACCOMMODATING AN ADVERSE
SUPPLY SHOCK
 In response to an adverse supply shock, the central bank has two options
 The first option, is to hold aggregate demand constant.
 In this case, output and employment are lower than the natural level.
 Eventually, prices will fall to restore full employment at the old price level (point A)
 the cost of this adjustment process is a painful recession

 Second is CB can increase aggregate

demand to prevent a reduction in output.
 The economy moves from point A to point
C.
 The cost of this policy is a permanently
higher level of prices.