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CHAPTER
9
Introduction to Economic
Fluctuations
Adapted for EC 204 by
Prof. Bob Murphy
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
from 4 8
quarters
earlier 6
Real GDP
growth rate
Consumption
growth rate
Average 4
growth
rate 2
0
-2
-4
1970
1975
1980
1985
1990
1995
2000
2005
Growth rates of real GDP, consumption, investment
Percent 40
change
from 4 30
quarters
earlier 20
Investment
growth rate
Real GDP
growth rate
10
0
Consumption
growth rate
-10
-20
-30
1970
1975
1980
1985
1990
1995
2000
2005
Unemployment
Percent 12
of labor
force
10
8
6
4
2
0
1970
1975
1980
1985
1990
1995
2000
2005
Okun’s Law
Percentage 10
change in
real GDP 8
1951
Y
 3.5  2 u
Y
1966
1984
6
2003
4
1987
2
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 7
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 8
Index of Leading Economic Indicators
160
1996 = 100
140
120
100
80
60
40
20
Source:
Conference
Board
0
1970
1975
1980
1985
1990
1995
2000
2005
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 10
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 11
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 12
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 13
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 14
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 15
The downward-sloping AD curve
An increase in the
price level causes
a fall in real money
balances (M/P ),
P
causing a
decrease in the
demand for goods
& services.
CHAPTER 9
Introduction to Economic Fluctuations
AD
Y
slide 16
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 17
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 18
The long-run aggregate supply
curve
P
LRAS
Y does not
depend on P,
so LRAS is
vertical.
Y
 F (K , L )
CHAPTER 9
Introduction to Economic Fluctuations
Y
slide 19
Long-run effects of an increase in M
P
In the long run,
this raises the
price level…
LRAS
An increase
in M shifts
AD to the
right.
P2
P1
AD2
AD1
…but leaves
output the same.
CHAPTER 9
Y
Introduction to Economic Fluctuations
Y
slide 20
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 21
The short-run aggregate supply curve
P
The SRAS
curve is
horizontal:
The price level
is fixed at a
predetermined
level, and firms
sell as much as
buyers demand.
CHAPTER 9
P
Introduction to Economic Fluctuations
SRAS
Y
slide 22
Short-run effects of an increase in M
In the short run
when prices are
sticky,…
P
…an increase
in aggregate
demand…
SRAS
AD2
AD1
P
…causes
output to rise.
CHAPTER 9
Y1
Introduction to Economic Fluctuations
Y2
Y
slide 23
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
equilibrium, if
then over time,
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 24
The SR & LR effects of M > 0
A = initial
equilibrium
B = new shortrun eq’m
after Fed
increases M
C = long-run
equilibrium
CHAPTER 9
P
LRAS
C
P2
P
B
A
Y
Introduction to Economic Fluctuations
Y2
SRAS
AD2
AD1
Y
slide 25
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 26
The effects of a negative demand shock
AD shifts left,
depressing output
and employment
in the short run.
Over time,
prices fall and
the economy
moves down its
demand curve
toward fullemployment.
CHAPTER 9
P
P
LRAS
B
P2
A
SRAS
C
AD1
AD2
Y2
Y
Introduction to Economic Fluctuations
Y
slide 27
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 28
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 29
CASE STUDY:
The 1970s oil shocks
The oil price shock
shifts SRAS up,
causing output and
employment to fall.
In absence of
further price
shocks, prices will
fall over time and
economy moves
back toward full
employment.
CHAPTER 9
P
P2
LRAS
B
SRAS2
A
P1
SRAS1
AD
Y2
Y
Introduction to Economic Fluctuations
Y
slide 30
CASE STUDY:
The 1970s oil shocks
70%
Predicted effects
of the oil shock:
• inflation 
• output 
• unemployment 
…and then a
gradual recovery.
12%
60%
50%
10%
40%
8%
30%
20%
6%
10%
0%
1973
1974
1975
1976
4%
1977
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
CHAPTER 9
Introduction to Economic Fluctuations
slide 31
CASE STUDY:
The 1970s oil shocks
60%
Late 1970s:
As economy
was recovering,
oil prices shot up
again, causing
another huge
supply shock!!!
14%
50%
12%
40%
10%
30%
8%
20%
6%
10%
0%
1977
4%
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 32
CASE STUDY:
The 1980s oil shocks
40%
1980s:
A favorable
supply shock-a significant fall
in oil prices.
As the model
predicts,
inflation and
unemployment
fell:
10%
30%
8%
20%
10%
6%
0%
-10%
4%
-20%
-30%
2%
-40%
-50%
1982
0%
1983
1984
1985
1986
1987
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
CHAPTER 9
Introduction to Economic Fluctuations
slide 33
Imported Crude Oil Prices: Nominal and Real
140
Projections
120
100
Real Price
Dollars
80
per
barrel
60
40
20
Nominal
Price
Jan-10
Jan-08
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
0
Short Term Energy Outlook-February 2009
CHAPTER 9
Introduction to Economic Fluctuations
slide 34
Real Gasoline Pump Price: Annual Average 1919- 2010
350
Projections
300
Real Price
250
Cents 200
per
Gallon 150
100
Nominal Price
50
2009
2004
1999
1994
1989
1984
1979
1974
1969
1964
1959
1954
1949
1944
1939
1934
1929
1924
1919
0
Short Term Energy Outlook-February 2009
CHAPTER 9
Introduction to Economic Fluctuations
slide 35
Regular Gasoline Prices: Nominal and Real
450
Projection
s
400
350
300
Real Price
Cents 250
per
200
Gallon
150
100
50
Nominal Price
Jan-10
Jan-08
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
0
Short Term Energy Outlook-February 2009
CHAPTER 9
Introduction to Economic Fluctuations
slide 36
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 37
Stabilizing output with
monetary policy
P
The adverse
supply shock
moves the
economy to
point B.
P2
LRAS
B
A
P1
SRAS1
AD1
Y2
CHAPTER 9
SRAS2
Y
Introduction to Economic Fluctuations
Y
slide 38
Stabilizing output with
monetary policy
But the Fed
accommodates
the shock by
raising agg.
demand.
results:
P is permanently
higher, but Y
remains at its fullemployment level.
CHAPTER 9
P
P2
LRAS
B
C
SRAS2
A
P1
AD1
Y2
Y
Introduction to Economic Fluctuations
AD2
Y
slide 39