Worth: Mankiw Economics 5e HAPTER 9 Introduction to Economic Fluctuations 249 Price level. P A Reduction in Aggregate Demand The economy begins in un equilibrium at point a A reduction in aggregate de 1. A fall in mand, perhaps caused by a de crease in the money supply from AS A to point B, where output is below its natural level. As prices fall, the economy gradually re covers from the recession. mov AD,ng from point B to point C 3... but in the the short long run affects only the price level. economy is in its long-run equilibrium, the short-run aggregate supply curve must cross this point as well. Now suppose that the Fed reduces the money supply and the aggregate de mand curve shifts downward, as in Figure 9-9. In the short run, prices are sticky so the economy moves from point a to point B Output and employment fall below their natural levels, which means the economy is in a recession. Over time, in response to the low demand, wages and prices fall. The gradual reduction in price level moves the economy downward along the aggregate demand curve to point C, which is the ng-run equilibrium In the new long-run equilibrium(point C), output and employment are back to their natural levels, but prices are lower than in the old long-run equilibrium (point A). Thus, a shift in aggregate demand affects output in the short run, but this effect dissipates over time as firms adjust their prices Gold, Greenbacks. and the Contraction of the 1870s The aftermath of the Civil War in the United States provides a vivid example how contractionary monetary policy affects the economy. Before the war, the United States was on a gold standard. Paper dollars were readily convertible into gold. Under this policy, the quantity of gold determined the money supply and the price level. In 1862, after the Civil War broke out, the Treasury announced that it would no longer redeem dollars for gold. In essence, this act replaced the gold standard with a system of fiat money. Over the next few years, the government printed large quantities of paper currency--called greenbacks for their color--and used User JoENA: Job EFFo1425: 6264_ch09: Pg 249: 27141#/eps at 100s wed,Feb13,200210:084User JOEWA:Job EFF01425:6264_ch09:Pg 249:27141#/eps at 100% *27141* Wed, Feb 13, 2002 10:08 AM economy is in its long-run equilibrium, the short-run aggregate supply curve must cross this point as well. Now suppose that the Fed reduces the money supply and the aggregate de￾mand curve shifts downward, as in Figure 9-9. In the short run, prices are sticky, so the economy moves from point A to point B. Output and employment fall below their natural levels, which means the economy is in a recession. Over time, in response to the low demand, wages and prices fall.The gradual reduction in the price level moves the economy downward along the aggregate demand curve to point C, which is the new long-run equilibrium. In the new long-run equilibrium (point C), output and employment are back to their natural levels, but prices are lower than in the old long-run equilibrium (point A).Thus, a shift in aggregate demand affects output in the short run, but this effect dissipates over time as firms adjust their prices. CHAPTER 9 Introduction to Economic Fluctuations | 249 figure 9-9 Price level, P Y Income, output, Y AD1 AD2 SRAS LRAS A C B 2. . . . lowers output in the short run . . . 3. . . . but in the long run affects only the price level. 1. A fall in aggregate demand . . . A Reduction in Aggregate Demand The economy begins in long-run equilibrium at point A. A reduction in aggregate de￾mand, perhaps caused by a de￾crease in the money supply, moves the economy from point A to point B, where output is below its natural level. As prices fall, the economy gradually re￾covers from the recession, mov￾ing from point B to point C. CASE STUDY Gold, Greenbacks, and the Contraction of the 1870s The aftermath of the Civil War in the United States provides a vivid example of how contractionary monetary policy affects the economy. Before the war, the United States was on a gold standard. Paper dollars were readily convertible into gold. Under this policy, the quantity of gold determined the money supply and the price level. In 1862, after the Civil War broke out, the Treasury announced that it would no longer redeem dollars for gold. In essence, this act replaced the gold standard with a system of fiat money. Over the next few years, the government printed large quantities of paper currency—called greenbacks for their color—and used