Worth: Mankiw Economics 5e User JoENA: Job EFFo1425: 6264_ch09: Pg 236: 24782#/eps at 100s wed,Feb13,200210:074
User JOEWA:Job EFF01425:6264_ch09:Pg 236:24782#/eps at 100% *24782* Wed, Feb 13, 2002 10:07 AM
Worth: Mankiw Economics 5e part IV Business Cycle Theory The Economy in the short run User JoENA: Job EFFo1425: 6264_ch09: Pg 237: 27129 #/eps at 100s wed,Feb13,200210:07
User JOEWA:Job EFF01425:6264_ch09:Pg 237:27129#/eps at 100% *27129* Wed, Feb 13, 2002 10:07 AM part IV Business Cycle Theory: The Economy in the Short Run
Worth: Mankiw Economics 5e CHAPTER NINE Introduction to Economic fluctuations The modern world regards business cycles much as the ancient egyptian regarded the overflowing of the Nile. The phenomenon recurs at intervals, it is of great importance to everyone, and natural causes of it are not in sight John Bates Clark, 1898 Economic fluctuations present a recurring problem for economists and policy makers. This problem is illustrated in Figure 9-1, which shows growth in real GDP for the U.S. economy. As you can see, although the economy experiences long-run growth that averages about 3.5 percent per year, this growth is not at all steady. Recessions--periods of falling incomes and rising unemployment-are frequent. In the recession of 1990, for instance, real GDP fell 2.2 percent from its peak to its trough, and the unemployment rate rose to 7.7 percent. During reces- sions, not only are more people unemployed, but those who are employed have shorter workweeks, as more workers have to accept part-time jobs and fewer workers have the opportunity to work overtime. When recessions end and the economy enters a boom, these effects work in reverse: incomes rise, unemploy ment falls, and workweeks expand Economists call these short-run fluctuations in output and employment the business cycle. Although this term suggests that economic fluctuations are regular and predictable, they are not. Recessions are as irregular as they are common. Sometimes they are close together, such as the recessions of 1980 and 1982. Sometimes they are far apart, such as the recessions of 1982 and 1990 In Parts II and Ill of this book, we developed theories to explain how the economy behaves in the long run. Those theories were based on the classical dichotomy-the premise that real variables, such as output and employment,are not affected by what happens to nominal variables, such as the money supply and the price level. Although classical theories are useful for explaining long-run trends, including the economic growth we observe from decade to decade, most economists believe that the classical dichotomy does not hold in the short run d, therefore, that classical theories cannot explain year-to-year fluctuations output and employment. Here, in Part IV, we see how economists explain these short-run fluctuation This chapter begins our analysis by discussing the key differences between the long run and the short run and by introducing the model of aggregate supply 238 User JOENA: Job EFFo1425: 6264_ch09: Pg 238: 27130#/eps at 100*mg wea,Feb13,200210:07AM
User JOEWA:Job EFF01425:6264_ch09:Pg 238:27130#/eps at 100% *27130* Wed, Feb 13, 2002 10:07 AM Economic fluctuations present a recurring problem for economists and policymakers. This problem is illustrated in Figure 9-1, which shows growth in real GDP for the U.S. economy. As you can see, although the economy experiences long-run growth that averages about 3.5 percent per year, this growth is not at all steady. Recessions—periods of falling incomes and rising unemployment—are frequent. In the recession of 1990, for instance, real GDP fell 2.2 percent from its peak to its trough, and the unemployment rate rose to 7.7 percent. During recessions, not only are more people unemployed, but those who are employed have shorter workweeks, as more workers have to accept part-time jobs and fewer workers have the opportunity to work overtime.When recessions end and the economy enters a boom, these effects work in reverse: incomes rise, unemployment falls, and workweeks expand. Economists call these short-run fluctuations in output and employment the business cycle. Although this term suggests that economic fluctuations are regular and predictable, they are not. Recessions are as irregular as they are common. Sometimes they are close together, such as the recessions of 1980 and 1982. Sometimes they are far apart, such as the recessions of 1982 and 1990. In Parts II and III of this book, we developed theories to explain how the economy behaves in the long run. Those theories were based on the classical dichotomy—the premise that real variables, such as output and employment, are not affected by what happens to nominal variables, such as the money supply and the price level. Although classical theories are useful for explaining long-run trends, including the economic growth we observe from decade to decade, most economists believe that the classical dichotomy does not hold in the short run and, therefore, that classical theories cannot explain year-to-year fluctuations in output and employment. Here, in Part IV, we see how economists explain these short-run fluctuations. This chapter begins our analysis by discussing the key differences between the long run and the short run and by introducing the model of aggregate supply Introduction to Economic Fluctuations 9 CHAPTER The modern world regards business cycles much as the ancient Egyptians regarded the overflowing of the Nile.The phenomenon recurs at intervals, it is of great importance to everyone, and natural causes of it are not in sight. — John Bates Clark, 1898 NINE 238 |
Worth: Mankiw Economics 5e HAPTER 9 Introduction to Economic Fluctuations 239 Real GDP growth rate Average growth rate 1960 1970 1975 1980 1985 1995 2000 Real GDP Growth in the United States Growth in real GDP averages about 3. 5 percent per year, as indicated by the orange line, but there are substantial fluctuations around this average Recessions are periods when the production of goods and services is declining, represented here by negative growth in real GDP Source: U.S. Department of Commerce. and aggregate demand. With this model we can show how shocks to the econ- omy lead to short-run fuctuations in output and employment Just as egypt now controls the flooding of the Nile valley with the Aswan Dam, modern society tries to control the business cycle with appropriate eco- nomic policies. The model we develop over the next several chapters shows how monetary and fiscal policies infuence the business cycle. We will see that these policies can potentially stabilize the economy or, if poorly conducted, make the problem of economic instability even w 9-1 Time Horizons in macroeconomics Before we start building a model of short-run economic fluctuations, let's step back and ask a fundamental question: Why do economists need different models or different time horizons? Why can, t we stop the course here and be content with the classical models developed in Chapters 3 through 8? The answer, as this book has consistently reminded its reader, is that classical macroeconomic theory applies to the long run but not to the short run. But why is this so? User JOENA: Job EFFo1425: 6264_ch09: Pg 239: 27131#eps at 100*gl wed,Feb13,200210:074
User JOEWA:Job EFF01425:6264_ch09:Pg 239:27131#/eps at 100% *27131* Wed, Feb 13, 2002 10:07 AM and aggregate demand.With this model we can show how shocks to the economy lead to short-run fluctuations in output and employment. Just as Egypt now controls the flooding of the Nile Valley with the Aswan Dam, modern society tries to control the business cycle with appropriate economic policies.The model we develop over the next several chapters shows how monetary and fiscal policies influence the business cycle.We will see that these policies can potentially stabilize the economy or, if poorly conducted, make the problem of economic instability even worse. 9-1 Time Horizons in Macroeconomics Before we start building a model of short-run economic fluctuations, let’s step back and ask a fundamental question:Why do economists need different models for different time horizons? Why can’t we stop the course here and be content with the classical models developed in Chapters 3 through 8? The answer, as this book has consistently reminded its reader, is that classical macroeconomic theory applies to the long run but not to the short run. But why is this so? CHAPTER 9 Introduction to Economic Fluctuations | 239 figure 9-1 Percentage change from 4 quarters earlier 10 8 6 4 2 0 2 4 1960 1965 Year 1970 1975 1980 1985 1990 1995 2000 Real GDP growth rate Average growth rate Real GDP Growth in the United States Growth in real GDP averages about 3.5 percent per year, as indicated by the orange line, but there are substantial fluctuations around this average. Recessions are periods when the production of goods and services is declining, represented here by negative growth in real GDP. Source: U.S. Department of Commerce
Worth: Mankiw Economics 5e 240 PART IV Business Cycle Theory: The Economy in the Short Run How the Short Run and Long Run Differ Most macroeconomists believe that the key difference between the short run and the long run is the behavior of prices. In the long run, prices are flexible and can re- spond to changes in supply or demand. In the short run, many prices are"sticky"at some predetermined level. Because prices behave differently in the short run than in the long run, economic policies have different effects over different time horizons. To see how the short run and the long run differ, consider the effects of a hange in monetary policy. Suppose that the Federal Reserve suddenly reduced the money supply by 5 percent. According to the classical model, which almost all economists agree describes the economy in the long run, the money supply affects nominal variables--variables measured in terms of money-but not real ariables. In the long run, a 5-percent reduction in the money supply lowers all prices(including nominal wages) by 5 percent whereas all real variables remain the same. Thus, in the long run, changes in the money supply do not cause fuc tuations in output or employme ent In the short run, however, many prices do not respond to changes in mone ary policy. A reduction in the money supply does not immediately cause all firms to cut the wages they pay, all stores to change the price tags on their goods, all mail-order firms to issue new catalogs, and all restaurants to print new menus Instead, there is little immediate change in many prices; that is, many prices are sticky. This short-run price stickiness implies that the short-run impact of change in the money supply is not the same as the lor ing-run impact A model of economic fluctuations must take into account this short-run price ickiness. We will see that the failure of prices to adjust quickly and completely means that, in the short run, output and employment must do some of the instead. In other words, during the time horizon over which prices are classical dichotomy no longer holds: nominal variables can influence real and the economy can deviate from the equilibrium predicted by the classical model CASE STUDY The Puzzle of Sticky Magazine Prices How sticky are prices? The answer to this question depends on what price we consider Some commodities, such as wheat, soybeans, and pork bellies, are traded on organized exchanges, and their prices change every minute. No one would call these prices sticky. Yet the prices of most goods and services change much less frequently. One survey found that 39 percent of firms change their price once a year, and another 10 percent change their prices less than once a year. The reasons for price stickiness are not always apparent. Consider, for example, the market for magazines. A study has documented that magazines change their ewsstand prices very infrequently. The typical magazine allows infation to erode I Alan S Blinder, On Sticky Prices: Academic Theories Meet the Real World, "in N.G. Mankiw ed, Monetary Policy(Chicago: University of Chicago Press, 1994): 117-154 A case study in Chap. ter 19 discusses this survey in more detail. User JOENA: Job EFFo1425: 6264_ch09: Pg 240: 27132#eps at 100*mm Wea,Feb13,200210:08AM
User JOEWA:Job EFF01425:6264_ch09:Pg 240:27132#/eps at 100% *27132* Wed, Feb 13, 2002 10:08 AM How the Short Run and Long Run Differ Most macroeconomists believe that the key difference between the short run and the long run is the behavior of prices. In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many prices are “sticky’’ at some predetermined level. Because prices behave differently in the short run than in the long run, economic policies have different effects over different time horizons. To see how the short run and the long run differ, consider the effects of a change in monetary policy. Suppose that the Federal Reserve suddenly reduced the money supply by 5 percent. According to the classical model, which almost all economists agree describes the economy in the long run, the money supply affects nominal variables—variables measured in terms of money—but not real variables. In the long run, a 5-percent reduction in the money supply lowers all prices (including nominal wages) by 5 percent whereas all real variables remain the same.Thus, in the long run, changes in the money supply do not cause fluctuations in output or employment. In the short run, however, many prices do not respond to changes in monetary policy. A reduction in the money supply does not immediately cause all firms to cut the wages they pay, all stores to change the price tags on their goods, all mail-order firms to issue new catalogs, and all restaurants to print new menus. Instead, there is little immediate change in many prices; that is, many prices are sticky. This short-run price stickiness implies that the short-run impact of a change in the money supply is not the same as the long-run impact. A model of economic fluctuations must take into account this short-run price stickiness. We will see that the failure of prices to adjust quickly and completely means that,in the short run,output and employment must do some of the adjusting instead. In other words, during the time horizon over which prices are sticky, the classical dichotomy no longer holds: nominal variables can influence real variables, and the economy can deviate from the equilibrium predicted by the classical model. 240 | PART IV Business Cycle Theory: The Economy in the Short Run CASE STUDY The Puzzle of Sticky Magazine Prices How sticky are prices? The answer to this question depends on what price we consider. Some commodities, such as wheat, soybeans, and pork bellies, are traded on organized exchanges, and their prices change every minute. No one would call these prices sticky.Yet the prices of most goods and services change much less frequently. One survey found that 39 percent of firms change their prices once a year, and another 10 percent change their prices less than once a year.1 The reasons for price stickiness are not always apparent. Consider, for example, the market for magazines. A study has documented that magazines change their newsstand prices very infrequently. The typical magazine allows inflation to erode 1 Alan S. Blinder,“On Sticky Prices:Academic Theories Meet the Real World,’’ in N. G. Mankiw, ed., Monetary Policy (Chicago: University of Chicago Press, 1994): 117–154.A case study in Chapter 19 discusses this survey in more detail
Worth: Mankiw Economics 5e HAPTER 9 Introduction to Economic Fluctuations 24 its real price by about 25 percent before it raises its nominal price. When inflation is 4 percent per year, the typical magazine changes its price about every six years Why do magazines keep their prices the same for so long? Economists do not have a definitive answer. The question is puzzling because it would seem that for magazines, the cost of a price change is small. To change prices, a mail-order firm must issue a new catalog and a restaurant must print a new menu, but a magazine publisher can simply print a new price on the cover of the next issue. Perhaps the cost to the publisher of charging the wrong price is also small. Or maybe cus tomers would find it inconvenient if the price of their favorite magazine As the magazine example shows, explaining at the microeconomic level why prices are sticky is sometimes hard. The cause of price stickiness is, therefore, an active area of research, which we discuss more fully in Chapter 19. In this chap ter, however, we simply assume that prices are sticky so we can start developing the link between sticky prices and the business cycle. Although not yet fully ex- plained, short-run price stickiness is widely believed to be crucial for under- standing short-run economic fuctuations The Model of Aggregate Supply and Aggregate Demand How does introducing sticky prices change our view of how the economy works We can answer this question by considering economists' two favorite words supply and demand. In classical macroeconomic theory, the amount of output depends on the conomy's ability to supply goods and services, which in turn depends on the supplies of capital and labor and on the available production technology. This is the essence of the basic classical model in Chapter 3, as well as of the Solow growth model in Chapters 7 and 8. Flexible prices are a crucial assumption of classical theory. The theory posits, sometimes implicitly, that prices adjust to en- sure that the ity of output demanded equals the quantity The economy works quite differently when prices are sticky. In this case, as we ill see, output also depends on the demand for goods and services Demand, in turn, is influenced by monetary policy, fiscal policy, and various other factors. Be cause monetary and fiscal policy can influence the economy's output over the time horizon when prices are sticky, price stickiness provides a rationale for why these policies may be useful in stabilizing the economy in the she ort run In the rest of this chapter, we develop a model that makes these ideas more pre- cise. The model of supply and demand, which we used in Chapter 1 to discuss the market for pizza, offers some of the most fundamental insights in economics.This model shows how the supply and demand for any good jointly determine the 2 Stephen G Cecchetti, "The Frequency of Price Adjustment: A Study of the Newsstand Prices of gazines, "Journal of Econometrics 31(1986): 255-274 User JoEkA: Job EFFo1425: 6264_ch09: Pg 241: 27133#/eps at 100+ wed,Feb13,200210:084
User JOEWA:Job EFF01425:6264_ch09:Pg 241:27133#/eps at 100% *27133* Wed, Feb 13, 2002 10:08 AM The Model of Aggregate Supply and Aggregate Demand How does introducing sticky prices change our view of how the economy works? We can answer this question by considering economists’ two favorite words— supply and demand. In classical macroeconomic theory, the amount of output depends on the economy’s ability to supply goods and services, which in turn depends on the supplies of capital and labor and on the available production technology.This is the essence of the basic classical model in Chapter 3, as well as of the Solow growth model in Chapters 7 and 8. Flexible prices are a crucial assumption of classical theory.The theory posits, sometimes implicitly, that prices adjust to ensure that the quantity of output demanded equals the quantity supplied. The economy works quite differently when prices are sticky. In this case, as we will see, output also depends on the demand for goods and services. Demand, in turn, is influenced by monetary policy, fiscal policy, and various other factors. Because monetary and fiscal policy can influence the economy’s output over the time horizon when prices are sticky, price stickiness provides a rationale for why these policies may be useful in stabilizing the economy in the short run. In the rest of this chapter,we develop a model that makes these ideas more precise.The model of supply and demand, which we used in Chapter 1 to discuss the market for pizza, offers some of the most fundamental insights in economics.This model shows how the supply and demand for any good jointly determine the CHAPTER 9 Introduction to Economic Fluctuations | 241 its real price by about 25 percent before it raises its nominal price.When inflation is 4 percent per year, the typical magazine changes its price about every six years.2 Why do magazines keep their prices the same for so long? Economists do not have a definitive answer.The question is puzzling because it would seem that for magazines, the cost of a price change is small.To change prices, a mail-order firm must issue a new catalog and a restaurant must print a new menu, but a magazine publisher can simply print a new price on the cover of the next issue. Perhaps the cost to the publisher of charging the wrong price is also small. Or maybe customers would find it inconvenient if the price of their favorite magazine changed every month. As the magazine example shows, explaining at the microeconomic level why prices are sticky is sometimes hard.The cause of price stickiness is, therefore, an active area of research, which we discuss more fully in Chapter 19. In this chapter, however, we simply assume that prices are sticky so we can start developing the link between sticky prices and the business cycle.Although not yet fully explained, short-run price stickiness is widely believed to be crucial for understanding short-run economic fluctuations. 2 Stephen G. Cecchetti,“The Frequency of Price Adjustment:A Study of the Newsstand Prices of Magazines,’’ Journal of Econometrics 31 (1986): 255–274
Worth: Mankiw Economics 5e 242 PART IV Business Cycle Theory: The Economy in the Short Run good's price and the quantity sold, and how shifts in supply and demand affect the price and quantity. In the rest of this chapter, we introduce the "economy-size version of this model-the model of aggregate supply and aggregate demand. This macroeconomic model allows us to study how the aggregate price level and the quantity of aggregate output are determined. It also provides a way to contrast how the economy behaves in the long run and how it behaves in the short run. Although the model of aggregate supply and aggregate demand resembles the model of supply and demand for a single good, the analogy is not exact. The model of supply and demand for a single good considers only one good within a large economy. By contrast, as we will see in the coming chapters, the model of aggregate supply and aggregate demand is a sophisticated model that incorpo- rates the interactions among many markets. 9-2 Aggregate Demand Aggregate demand (AD)is the relationship between the quantity of output demanded and the aggregate price level. In other words, the aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices. We examine the theory of aggregate demand in detail in Chapters 10 through 12. Here we use the quantity theory of money to provide a simple, although incomplete, derivation of the aggregate demand curve. The Quantity Equation as Aggregate Demand Recall from Chapter 4 that the quantity theory says that MV=PY, where M is the money supply, v is the velocity of money, P is the price level, and Y is the amount of output. If the velocity of money is constant, then this equa You might recall that the quantity equation can be rewritten in terms of the pply and demand for real money balances M/P=(M/p)=kY where k= 1/V is a parameter determining how much money people want to hold for every dollar of income. In this form, the quantity equation states that the supply of real money balances M/P equals the demand (M/p)and that the de- mand is proportional to output Y. The velocity of money V is the "flip side" of the money demand parameter k For any fixed money supply and velocity, the quantity equation yields a nega- tive relationship between the price level P and output Y. Figure 9-2 graphs the combinations of P and Y that satisfy the quantity equation holding M and V constant.This downward-sloping curve is called the aggregate demand curve User JOENA: Job EFFo1425: 6264_ch09: Pg 242: 27134#/eps at 100*ml Wea,Feb13,200210:08AM
User JOEWA:Job EFF01425:6264_ch09:Pg 242:27134#/eps at 100% *27134* Wed, Feb 13, 2002 10:08 AM good’s price and the quantity sold, and how shifts in supply and demand affect the price and quantity. In the rest of this chapter, we introduce the “economy-size’’ version of this model—the model of aggregate supply and aggregate demand. This macroeconomic model allows us to study how the aggregate price level and the quantity of aggregate output are determined. It also provides a way to contrast how the economy behaves in the long run and how it behaves in the short run. Although the model of aggregate supply and aggregate demand resembles the model of supply and demand for a single good, the analogy is not exact. The model of supply and demand for a single good considers only one good within a large economy. By contrast, as we will see in the coming chapters, the model of aggregate supply and aggregate demand is a sophisticated model that incorporates the interactions among many markets. 9-2 Aggregate Demand Aggregate demand (AD) is the relationship between the quantity of output demanded and the aggregate price level. In other words, the aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices.We examine the theory of aggregate demand in detail in Chapters 10 through 12. Here we use the quantity theory of money to provide a simple, although incomplete, derivation of the aggregate demand curve. The Quantity Equation as Aggregate Demand Recall from Chapter 4 that the quantity theory says that MV = PY, where M is the money supply,V is the velocity of money, P is the price level, and Y is the amount of output. If the velocity of money is constant, then this equation states that the money supply determines the nominal value of output, which in turn is the product of the price level and the amount of output. You might recall that the quantity equation can be rewritten in terms of the supply and demand for real money balances: M/P = (M/P) d = kY, where k = 1/V is a parameter determining how much money people want to hold for every dollar of income. In this form, the quantity equation states that the supply of real money balances M/P equals the demand (M/P) d and that the demand is proportional to output Y.The velocity of money V is the “flip side” of the money demand parameter k. For any fixed money supply and velocity, the quantity equation yields a negative relationship between the price level P and output Y. Figure 9-2 graphs the combinations of P and Y that satisfy the quantity equation holding M and V constant.This downward-sloping curve is called the aggregate demand curve. 242 | PART IV Business Cycle Theory: The Economy in the Short Run
Worth: Mankiw Economics 5e HAPTER 9 Introduction to Economic Fluctuations 243 figure 9-2 Price level. P The Aggregate Demand Curve The aggregate demand curve AD shows the relationship betweer he price level P and the quantity of goods and services demanded Y, It is drawn for a given value of the money supply M. The aggre gate demand curve slopes down ward: the higher the price level the lower the level of real balances M/P, and therefore the lower the quantity of goods and services Income, output, Y Why the Aggregate Demand Curve Slopes Downward As a strictly mathematical matter, the quantity equation explains the downward slope of the aggregate demand curve very simply. The money supply M and the velocity of money V determine the nominal value of output PY. Once PY is fixed, if P goes up, Y must go down. What is the economics that lies behind this mathematical relationship? For a omplete answer, we have to wait for a couple of chapters. For now, however consider the following logic: Because we have assumed the velocity of money is fixed, the money supply determines the dollar value of all transactions in the economy.(This conclusion should be familiar from Chapter 4. If the price level rises, each transaction requires more dollars, so the number of transactions and hus the quantity of goods and services purchased must fall We can also explain the downward slope of the aggregate demand curve by thinking about the supply and demand for real money balances. If output is higher, people engage in more transactions and need higher real balances M/P. For a fixed money supply M, higher real balances imply a lower price level. Con- versely, if the price level is lower, real money balances are higher; the higher level of real balances allows a greater volume of transactions, which means a greater quantity of output is demanded. Shifts in the Aggregate Demand Curve The aggregate demand curve is drawn for a fixed value of the money supply. In other words, it tells us the possible combinations of P and Y for a given value of M. If the Fed changes the money supply, then the possible combinations of P and Y change, which means the aggregate demand curve shifts User JOENA: Job EFFo1425: 6264_ch09: Pg 243: 27135#/eps at 100*mli wed,Feb13,200210:084
User JOEWA:Job EFF01425:6264_ch09:Pg 243:27135#/eps at 100% *27135* Wed, Feb 13, 2002 10:08 AM Why the Aggregate Demand Curve Slopes Downward As a strictly mathematical matter, the quantity equation explains the downward slope of the aggregate demand curve very simply.The money supply M and the velocity of money V determine the nominal value of output PY. Once PY is fixed, if P goes up, Y must go down. What is the economics that lies behind this mathematical relationship? For a complete answer, we have to wait for a couple of chapters. For now, however, consider the following logic: Because we have assumed the velocity of money is fixed, the money supply determines the dollar value of all transactions in the economy. (This conclusion should be familiar from Chapter 4.) If the price level rises, each transaction requires more dollars, so the number of transactions and thus the quantity of goods and services purchased must fall. We can also explain the downward slope of the aggregate demand curve by thinking about the supply and demand for real money balances. If output is higher, people engage in more transactions and need higher real balances M/P. For a fixed money supply M, higher real balances imply a lower price level. Conversely, if the price level is lower, real money balances are higher; the higher level of real balances allows a greater volume of transactions, which means a greater quantity of output is demanded. Shifts in the Aggregate Demand Curve The aggregate demand curve is drawn for a fixed value of the money supply. In other words, it tells us the possible combinations of P and Y for a given value of M. If the Fed changes the money supply, then the possible combinations of P and Y change, which means the aggregate demand curve shifts. CHAPTER 9 Introduction to Economic Fluctuations | 243 figure 9-2 Price level, P Income, output, Y Aggregate demand, AD The Aggregate Demand Curve The aggregate demand curve AD shows the relationship between the price level P and the quantity of goods and services demanded Y. It is drawn for a given value of the money supply M. The aggregate demand curve slopes downward: the higher the price level P, the lower the level of real balances M/P, and therefore the lower the quantity of goods and services demanded Y
Worth: Mankiw Economics 5e 244 PART IV Business Cycle Theory: The Economy in the Short Run For example, consider what happens if the Fed reduces the money supply. The quantity equation, MV= PY, tells us that the reduction in the money supply ads to a proportionate reduction in the nominal value of output PY. For any given price level, the amount of output is lower, and for any given amount of output, the price level is lower. As in Figure 9-3(a), the aggregate demand curve relating P and Y shifts inward fi (a)Inward Shifts in the Aggregate Demand Curve Shifts in the Aggregate Deman Price level. P Curve Changes in the money supply shift the aggregate de- mand curve In panel(a), a de Reductions in the money supply shift outpu PY. For any given price the aggregate demand level P, output Y is lower. Thus a decrease in the money supply shifts the aggregate demand curve inward from AD, to AD2 In panel(b), an increase in the money supply M raises the nomi- nal value of output PY. For any higher. Thus, an increase in the oney supply shifts the agg gate demand curve outward wed,Feb13,200210:084
User JOEWA:Job EFF01425:6264_ch09:Pg 244:27136#/eps at 100% *27136* Wed, Feb 13, 2002 10:08 AM For example, consider what happens if the Fed reduces the money supply.The quantity equation, MV = PY, tells us that the reduction in the money supply leads to a proportionate reduction in the nominal value of output PY. For any given price level, the amount of output is lower, and for any given amount of output, the price level is lower.As in Figure 9-3(a), the aggregate demand curve relating P and Y shifts inward. 244 | PART IV Business Cycle Theory: The Economy in the Short Run figure 9-3 Price level, P Income, output, Y (a) Inward Shifts in the Aggregate Demand Curve AD2 AD1 Reductions in the money supply shift the aggregate demand curve to the left. Shifts in the Aggregate Demand Curve Changes in the money supply shift the aggregate demand curve. In panel (a), a decrease in the money supply M reduces the nominal value of output PY. For any given price level P, output Y is lower. Thus, a decrease in the money supply shifts the aggregate demand curve inward from AD1 to AD2. In panel (b), an increase in the money supply M raises the nominal value of output PY. For any given price level P, output Y is higher. Thus, an increase in the money supply shifts the aggregate demand curve outward from AD1 to AD2. Price level, P Income, output, Y (b) Outward Shifts in the Aggregate Demand Curve Increases in the money supply shift the aggregate demand curve to the right. AD1 AD2
Worth: Mankiw Economics 5e HAPTER 9 Introduction to Economic Fluctuations 245 The opposite occurs if the Fed increases the money supply. The quantity equation tells us that an increase in M leads to an increase in PY. For any giv ven price level, the amount of output is higher, and for any gi Iven amou unt of the price level is higher. As shown in Figure 9-3(b), the aggregate demand curve shifts outward Fluctuations in the money supply are not the only source of fluctuations in aggregate demand. Even if the money supply is held constant, the aggregate de- mand curve shifts if some event causes a change in the velocity of money. Over the next three chapters, we consider many possible reasons for shifts in the aggre- ate demand curve 9-3 Aggregate Supply By itself, the aggregate demand curve does not tell us the price level or the amount of output; it merely gives a relationship between these two variables To accompany the aggregate demand curve, we need another relationship between P and Y that crosses the aggregate demand curve- an aggregate supply curve. The aggregate demand and aggregate supply curves together pin down the economys price level and quantity of output. 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 fexible prices in the long run but sticky prices in the short run, the aggregate supply relationship depends on the time horizon. We need to discuss two different aggregate supply curves: the long-run aggregate supply curve LRAS and the short-run aggregate supply curve SRAS. We also need to discuss how the economy makes the transition from the short run to the long run. The Long Run: The Vertical Aggregate Supply Curve Because the classical model describes how the economy behaves in the long run, we derive the long-run aggregate supply curve from the classical model. Recall from Chapter 3 that the amount of output produced depends on the fixed amounts of capital and labor and on the available technology. To show his. we write Y=F(K, L) According to the classical model, output does not depend on the price level. To show that output is the same for all price levels, we draw a vertical aggregate supply curve, as in Figure 9-4. The intersection of the aggregate demand curve with this vertical aggregate supply curve determines the price level f If the aggregate supply curve is vertical, then changes in aggregate demand af- ct prices but not output. For example, if the money supply falls, the aggregate wed,Feb13,200210:084
User JOEWA:Job EFF01425:6264_ch09:Pg 245:27137#/eps at 100% *27137* Wed, Feb 13, 2002 10:08 AM The opposite occurs if the Fed increases the money supply. The quantity equation tells us that an increase in M leads to an increase in PY. For any given price level, the amount of output is higher, and for any given amount of output, the price level is higher.As shown in Figure 9-3(b), the aggregate demand curve shifts outward. Fluctuations in the money supply are not the only source of fluctuations in aggregate demand. Even if the money supply is held constant, the aggregate demand curve shifts if some event causes a change in the velocity of money. Over the next three chapters, we consider many possible reasons for shifts in the aggregate demand curve. 9-3 Aggregate Supply By itself, the aggregate demand curve does not tell us the price level or the amount of output; it merely gives a relationship between these two variables.To accompany the aggregate demand curve, we need another relationship between P and Y that crosses the aggregate demand curve—an aggregate supply curve. The aggregate demand and aggregate supply curves together pin down the economy’s price level and quantity of output. 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.We need to discuss two different aggregate supply curves: the long-run aggregate supply curve LRAS and the short-run aggregate supply curve SRAS.We also need to discuss how the economy makes the transition from the short run to the long run. The Long Run: The Vertical Aggregate Supply Curve Because the classical model describes how the economy behaves in the long run, we derive the long-run aggregate supply curve from the classical model. Recall from Chapter 3 that the amount of output produced depends on the fixed amounts of capital and labor and on the available technology. To show this, we write Y = F(K _ , L _ ) = Y _ . According to the classical model, output does not depend on the price level.To show that output is the same for all price levels, we draw a vertical aggregate supply curve, as in Figure 9-4.The intersection of the aggregate demand curve with this vertical aggregate supply curve determines the price level. If the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not output. For example, if the money supply falls, the aggregate CHAPTER 9 Introduction to Economic Fluctuations | 245
