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,Feb13,200210:084User 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 en￾sure 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. 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 short 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 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 cus￾tomers 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 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 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