10

Introduction to Economic Fluctuations

MACROECONOMICS
N. Gregory Mankiw
® Fall 2013
PowerPoint Slides by Ron Cronovich
update
© 2014 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.”

1
 Facts about the business cycle (ciclo
economico)
 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 10 Introduction to Economic Fluctuations 2
 Unemployment
Percent 12
of labor
force
10

0
1970 1975 1980 1985 1990 1995 2000 2005 2010
 Okun’s Law
Percentage 10 Y
change in
1951 1966  3  2 u
real GDP 8 Y
1984
6
2003

4 1971
1987
2

2001 1975
0

-2 2008 2009
1991 1982
-4
-3 -2 -1 0 1 2 3 4
Change in unemployment rate
 Growth rates of real GDP, consumption
Percent 10 Real GDP
change growth rate
from 4 8 Consumption
quarters growth rate
earlier
6

Average 4
growth
rate 2

-2

-4
1970 1975 1980 1985 1990 1995 2000 2005 2010
Growth rates of real GDP, consump., investment
Percent
change 40 Investment
from 4 growth rate
quarters 30
earlier
20
Real GDP
10 growth rate

0
Consumption
-10 growth rate

-20

-30
1970 1975 1980 1985 1990 1995 2000 2005 2010
 Índice de indicadores económicos
adelantados

 Lo publica mensualmente por la “Conference

Board”.
 Su objetivo es pronosticar los cambios en la
actividad económica a 6-9 meses vista.
 Lo utilizan empresarios y gobierno para sus
planes, a pesar de no ser un predictor perfecto.

CHAPTER 10 Introduction to Economic Fluctuations 7

 Componentes del índice de IEA
 La semana laboral media de los obreros industriales
 Variación semanal media del paro
 Nuevos pedidos de bienes de consumo y materias primas
 Nuevos pedidos de bienes de capital civiles
 Ventas de los proveedores
 Nuevos pedidos de construcción concedidos
 Índice de cotizaciones bursátiles
 La oferta monetaria M2
 Diferencia de tipos de interés de las letras del tesoro (10 años
menos 3 meses)
 El índice de confianza de los consumidores

CHAPTER 10 Introduction to Economic Fluctuations 8

 Índice de indicadores económicos adelantados

160

140

120
1996 = 100

100

80

60

40

20

Fuente:
0
Conference 1970 1975 1980 1985 1990 1995 2000 2005
CHAPTER 10 Introduction to Economic Fluctuations 9
Board
 Time horizons in macroeconomics
 Long run
Prices are flexible, respond to changes in supply
or demand.
 Short run
Many prices are “sticky” at a predetermined
level.

The economy behaves much

differently when prices are sticky.

CHAPTER 10 Introduction to Economic Fluctuations 10

 NOW YOU TRY
Sticky vs. flexible prices

 Think about an example for prices that might be

sticky in the short run, but flexible in the long
run.

CHAPTER 10 Introduction to Economic Fluctuations 11

 In classical macroeconomic theory,
(recap Chaps. 3, 7+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 10 Introduction to Economic Fluctuations 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 10 Introduction to Economic Fluctuations 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 10 Introduction to Economic Fluctuations 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 10 Introduction to Economic Fluctuations 15

 The quantity theory of money
 A simple theory linking the inflation rate to the
growth rate of the money supply.
 Begins with the concept of velocity…

CHAPTER 10 Introduction to Economic Fluctuations 16

 Velocity
 basic concept:
the rate at which money circulates
 definition: the number of times the average
dollar bill changes hands in a given time period
 example: In 2012,
 $500 billion in transactions
 money supply = $100 billion
 The average dollar is used in five transactions
in 2012
 So, velocity = 5
CHAPTER 10 Introduction to Economic Fluctuations 17
 Velocity, cont.
 This suggests the following definition:
T
V
M
where
V = velocity
T = value of all transactions
M = money supply

CHAPTER 10 Introduction to Economic Fluctuations 18

 Velocity, cont.
 Use nominal GDP as a proxy for total
transactions.
Then, P Y
V
M
where
P = price of output (GDP deflator)
Y = quantity of output (real GDP)
P  Y = value of output (nominal GDP)

CHAPTER 10 Introduction to Economic Fluctuations 19

 NOW YOU TRY
The velocity of money

 Assume the velocity of money is 10, and

nominal GDP equals 2000. What is the money
supply in the economy?
 Now assume that the nominal GDP grows by
5%, but the real money supply only grows by
2%. What does this imply for the velocity of
money?

CHAPTER 10 Introduction to Economic Fluctuations 20

 The quantity equation
 The quantity equation
MV = PY
follows from the preceding definition of velocity.
 It is an identity:
it holds by definition of the variables.

CHAPTER 10 Introduction to Economic Fluctuations 21

 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
& services. AD
Y

CHAPTER 10 Introduction to Economic Fluctuations 22

 Shifting the AD curve

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

AD2
AD1
Y

CHAPTER 10 Introduction to Economic Fluctuations 23

 Aggregate supply in the long run

 Recall from Chap. 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, at which the economy’s resources are
fully employed.
“Full employment” means that
unemployment equals its natural rate (not zero).
CHAPTER 10 Introduction to Economic Fluctuations 24
 The long-run aggregate supply curve

P LRAS
Y does not
depend on P,
so LRAS is
vertical.

Y
Y
 F (K , L )
CHAPTER 10 Introduction to Economic Fluctuations 25
 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 10 Introduction to Economic Fluctuations 26

 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 10 Introduction to Economic Fluctuations 27

 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 10 Introduction to Economic Fluctuations 28

 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 10 Introduction to Economic Fluctuations 29
 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 10 Introduction to Economic Fluctuations 30
 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 10 Introduction to Economic Fluctuations 31

 Economic Shocks

 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 10 Introduction to Economic Fluctuations 32

 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 10 Introduction to Economic Fluctuations 33
 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 10 Introduction to Economic Fluctuations 34
 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 10 Introduction to Economic Fluctuations 35

 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 10 Introduction to Economic Fluctuations 36
 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 10 Introduction to Economic Fluctuations 37
 CASE STUDY:
The 1970s oil shocks
60% 14%
Late 1970s: 50% 12%
As economy
40%
was recovering, 10%
oil prices shot up 30%
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 10 Introduction to Economic Fluctuations 38
 CASE STUDY:
The 1980s oil shocks
40% 10%
1980s: 30%
20% 8%
A favorable
supply shock— 10%
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 10 Introduction to Economic Fluctuations 39
 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 10 Introduction to Economic Fluctuations 40

 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 10 Introduction to Economic Fluctuations 41

 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
employment level. Y2 Y

CHAPTER 10 Introduction to Economic Fluctuations 42

 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
government, despite not being a perfect
predictor.

CHAPTER 10 Introduction to Economic Fluctuations 43

 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 10 Introduction to Economic Fluctuations 44
 Index of Leading Economic Indicators,
1970-2012
120
110
100
90
2004 = 100

80
70
60
50
40
30
20
10
Source: 0
Conference
CHAPTER197010 Introduction
1975 to Economic
1980 1985 Fluctuations
1990 1995 2000 2005 2010 45
Board
 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

46
 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.

47
 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.

48