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MMACROECONOMICSACROECONOMICS
C H A P T E R
© 2007 Worth Publishers, all rights reserved
SIXTH EDITIONSIXTH EDITION
PowerPointPowerPoint®® Slides by Ron Cronovich Slides by Ron Cronovich
NN. . GGREGORY REGORY MMANKIWANKIW
Introduction to EconomicFluctuations
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CHAPTER 9 Introduction to Economic Fluctuations slide 1
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 shortrun and long run
how the model of aggregate demand andaggregate supply can be used to analyze theshort-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 overthe long run with large fluctuations in the short run.
Consumption and investment fluctuate with GDP,but consumption tends to be less volatile andinvestment more volatile than GDP.
Unemployment rises during recessions and fallsduring expansions.
Okun’s Law: the negative relationship betweenGDP and unemployment.
Growth rates of real GDP, consumption
-4
-2
0
2
4
6
8
10
1970 1975 1980 1985 1990 1995 2000 2005
Real GDPgrowth rate
Averagegrowth
rate
Consumptiongrowth rate
Percentchangefrom 4
quartersearlier
Growth rates of real GDP, consumption, investment
-30
-20
-10
0
10
20
30
40
1970 1975 1980 1985 1990 1995 2000 2005
Percentchangefrom 4
quartersearlier
Investmentgrowth rate
Real GDPgrowth rate
Consumptiongrowth rate
Unemployment
0
2
4
6
8
10
12
1970 1975 1980 1985 1990 1995 2000 2005
Percentof labor
force
2
Okun’s Law
Percentagechange inreal GDP
Change in unemployment rate
-4
-2
0
2
4
6
8
10
-3 -2 -1 0 1 2 3 4
1975
198219912001
1984
1951 1966
2003
1987
3.5 2!
!= "Y
uY
CHAPTER 9 Introduction to Economic Fluctuations slide 7
Index of Leading Economic Indicators
Published monthly by the Conference Board.
Aims to forecast changes in economic activity6-9 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
Index of Leading Economic Indicators
0
20
40
60
80
100
120
140
160
1970 1975 1980 1985 1990 1995 2000 2005
1996
= 1
00
Source:ConferenceBoard
CHAPTER 9 Introduction to Economic Fluctuations slide 10
Time horizons in macroeconomics
Long run:Prices are flexible, respond to changes in supplyor demand.
Short run:Many prices are “sticky” at some predeterminedlevel.
The economy behaves muchdifferently 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.
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CHAPTER 9 Introduction to Economic Fluctuations slide 12
When prices are sticky…
…output and employment also depend ondemand, 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 ofaggregate demand and supply
the paradigm most mainstream economistsand policymakers use to think about economicfluctuations and policies to stabilize the economy
shows how the price level and aggregate outputare determined
shows how the economy’s behavior is differentin the short run and long run
CHAPTER 9 Introduction to Economic Fluctuations slide 14
Aggregate demand
The aggregate demand curve shows therelationship between the price level and thequantity of output demanded.
For this chapter’s intro to the AD/AS model,we use a simple theory of aggregate demandbased on the quantity theory of money.
Chapters 10-12 develop the theory of aggregatedemand in more detail.
CHAPTER 9 Introduction to Economic Fluctuations slide 15
The Quantity Equation asAggregate Demand
From Chapter 4, recall the quantity equation
M V = P Y
For given values of M and V,this equation implies an inverse relationshipbetween P and Y :
CHAPTER 9 Introduction to Economic Fluctuations slide 16
The downward-sloping AD curve
An increase in theprice level causesa fall in real moneybalances (M/P ),
causing adecrease in thedemand for goods& services.
Y
P
AD
CHAPTER 9 Introduction to Economic Fluctuations slide 17
Shifting the AD curve
An increase inthe money supplyshifts the ADcurve to the right.
Y
P
AD1
AD2
4
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 byfactor supplies and technology
,= ( )Y F K L
is the full-employment or natural level ofoutput, the level of output at which theeconomy’s resources are fully employed.
Y
“Full employment” means thatunemployment equals its natural rate (not zero).
CHAPTER 9 Introduction to Economic Fluctuations slide 19
The long-run aggregate supplycurve
Y
P LRAS
does notdepend on P,so LRAS isvertical.
Y
( )= ,
Y
F K L
CHAPTER 9 Introduction to Economic Fluctuations slide 20
Long-run effects of an increase in M
Y
P
AD1
LRAS
Y
An increasein M shiftsAD to theright.
P1
P2In the long run,this raises theprice level…
…but leavesoutput the same.
AD2
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
Y
P
PSRAS
The SRAScurve ishorizontal:
The price levelis fixed at apredeterminedlevel, and firmssell as much asbuyers demand.
CHAPTER 9 Introduction to Economic Fluctuations slide 23
Short-run effects of an increase in M
Y
P
AD1
In the short runwhen prices aresticky,…
…causesoutput to rise.
PSRAS
Y2Y1
AD2
…an increasein aggregatedemand…
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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?
Y Y>
Y Y<
Y Y=
rise
fall
remain constant
In the short-runequilibrium, if
then over time,P will…
The adjustment of prices is what moves theeconomy to its long-run equilibrium.
CHAPTER 9 Introduction to Economic Fluctuations slide 25
The SR & LR effects of ΔM > 0
Y
P
AD1
LRAS
Y
PSRAS
P2
Y2
A = initialequilibrium
AB
CB = new short-
run eq’mafter Fedincreases M
C = long-runequilibrium
AD2
CHAPTER 9 Introduction to Economic Fluctuations slide 26
How shocking!!!
shocks: exogenous changes in agg. supply ordemand
Shocks temporarily push the economy away fromfull employment.
Example: exogenous decrease in velocityIf the money supply is held constant, a decrease inV means people will be using their money in fewertransactions, causing a decrease in demand forgoods and services.
CHAPTER 9 Introduction to Economic Fluctuations slide 27
PSRAS
LRAS
AD2
The effects of a negative demand shock
Y
P
AD1
Y
P2
Y2
AD shifts left,depressing outputand employmentin the short run.
AB
C
Over time,prices fall andthe economymoves down itsdemand curvetoward full-employment.
CHAPTER 9 Introduction to Economic Fluctuations slide 28
Supply shocks
A supply shock alters production costs, affects theprices 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 tohelp 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 inthe supply of oil.
Oil prices rose11% in 1973 68% in 1974 16% in 1975
Such sharp oil price increases are supply shocksbecause they significantly impact productioncosts and prices.
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CHAPTER 9 Introduction to Economic Fluctuations slide 30
1P
SRAS1
Y
P
AD
LRAS
YY2
CASE STUDY:The 1970s oil shocks
The oil price shockshifts SRAS up,causing output andemployment to fall.
A
B
In absence offurther priceshocks, prices willfall over time andeconomy movesback toward fullemployment.
2P
SRAS2
A
CHAPTER 9 Introduction to Economic Fluctuations slide 34
Stabilization policy
def: policy actions aimed at reducing theseverity of short-run economic fluctuations.
Example: Using monetary policy to combat theeffects of adverse supply shocks:
CHAPTER 9 Introduction to Economic Fluctuations slide 35
Stabilizing output withmonetary policy
1P
SRAS1
Y
P
AD1
B
A
Y2
LRAS
Y
The adversesupply shockmoves theeconomy topoint B.
2P
SRAS2
CHAPTER 9 Introduction to Economic Fluctuations slide 36
Stabilizing output withmonetary policy
1P
Y
P
AD1
B
A
C
Y2
LRAS
Y
But the Fedaccommodatesthe shock byraising agg.demand.
results:P is permanentlyhigher, but Yremains at its full-employment level.
2P
SRAS2
AD2
Chapter SummaryChapter Summary
1. Long run: prices are flexible, output and employmentare always at their natural rates, and the classicaltheory applies.Short run: prices are sticky, shocks can push outputand employment away from their natural rates.
2. Aggregate demand and supply:a framework to analyze economic fluctuations
CHAPTER 9 Introduction to Economic Fluctuations slide 37
Chapter SummaryChapter Summary
3. The aggregate demand curve slopes downward.
4. The long-run aggregate supply curve is vertical,because output depends on technology and factorsupplies, 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 38
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Chapter SummaryChapter Summary
6. Shocks to aggregate demand and supply causefluctuations in GDP and employment in the short run.
7. The Fed can attempt to stabilize the economy withmonetary policy.
CHAPTER 9 Introduction to Economic Fluctuations slide 39
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