1. MANKIW'S MACROECONOMICS MODULES
MANKIW'S MACROECONOMICS MODULES
CHAPTER 9
Introduction to Economic Fluctuations
A PowerPointTutorial
To Accompany
MACROECONOMICS, 7th. Edition
N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian
B.A. in Economics with Distinction, Duke University
M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management

2. A recent recession began in late 2007
From the 4th quarter of 2007 to the 3rd quarter of 2008, the economy’s production of goods and services expanded by a paltry .7%-- well below the normal rate of growth. In the 4th quarter of 2008, real GDP fell at an annualized rate of 3.8 percent.
The unemployment rate rose from 4.7 percent in November
2007 to 7.6 percent in January In early 2009, as this
book was going to press, the end of the recession was not yet in
sight, and many feared that the downturn would get significantly
worse before getting better. As the book was going to press, the end of the recession was not in sight. Not surprisingly, the recession dominated the economic news of the time and the problem was high on the agenda of the newly elected president, Barack Obama.

3. The Business Cycle
Short-run fluctuations in output and employment are called the business cycle. In previous chapters, we developed theories to explain how the economy behaves in the long run; now we’ll seek to understand how the economy behaves in the short run.

4. GDP and Its Componants
GDP is the first place to start when analyzing the business cycle,
since it is the largest gauge of economic conditions.
The National Bureau of Economic Research (NBER) is the official
determiner of whether the economy is suffering from a recession.
A recession is usually defined by a period in which there are two
consecutive declines in real GDP.
In recessions, both consumption and investment decline; however,
investment (business equipment, structures, new housing and
inventories) is even more susceptible to decline.

5. Okun's Law
In recessions, unemployment rises. This negative (when one rises, the other falls) relationship between unemployment and GDP is called Okun’s Law, after Arthur Okun, the economist who first studied it. In short, it is defined as:
Percentage Change in Real GDP =
3.5% - 2  the Change in the Unemployment Rate
If the unemployment rate remains the same, real GDP grows by
about 3.5 percent. For every percentage point the unemployment rate
rises, real GDP growth typically falls by 2 percent. Hence, if the
unemployment rate rises from 5 to 8 percent, then real GDP growth
would be:
Percentage Change in Real GDP = 3.5% - 2  (8% - 5%) = - 2.5%
In this case, GDP would fall by 2.5%, indicating that the economy
is in a recession.

6. Leading Economic Indicators
Many economists in business and government have the role
of forecasting short-run fluctuations in the economy. One way
that economists arrive at forecasts is through looking at leading
indicators.
Each month, the Conference Board, a private economics
Research announces the index of leading economic indicators,
which consists of 10 data series.

7. Index of Leading Economic Indicators
Average workweek of production workers in manufacturing
Average initial weekly claims for unemployment insurance
New orders for consumer goods and materials adjusted for inflation
New orders, nondefense capital goods
Vendor performance
New building permits issued
Index of stock prices
Money-supply (M2) adjusted for inflation
Interest rate spread: the yield spread between 10-year Treasury
notes and 3-month treasury bills
10) Index of consumer expectations

8. The Crystal Ball of Economic Indicators
How has the crystal ball done lately? Here is what the Conference Board announced in 2007 press release:
The leading index decreased sharply for the second consecutive
month in November, and it has been down in four of the last
six months. Most of the leading indicators contributed negatively
to the index in November, led by large declines in stock prices,
initial claims for unemployment insurance, index of consumer
expectations, and the real money supply (M2)…The leading
index fell 1.2 percent (a decline of 2.3 percent annual rate) from
May to November, the largest six-month decrease in the index
in six years.
As predicted, the economy in 2008 and 2009 headed into a
recession.

9. Time Horizons in Macroeconomics
Classical macroeconomic theory applies to the long run but not to the short run–WHY?
The short run and long run differ in terms of the treatment 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.
Let’s see this in action.

10. The Classical Dichotomy
Recall from Chapter 4, the theoretical separation of real and nominal
variables is called…
The Classical Dichotomy
Economists call the separation of the determinants of real and nominal variables the classical dichotomy. A simplification of economic theory, it suggests that changes in the money supply do not influence real variables.
This irrelevance of money for real variables is called monetary neutrality. Most economists believe that these classical ideas describe how the economy works in the long run.

11. The Model of Aggregate Supply
and Aggregate Demand

12. This macroeconomic model allows us to examine how the aggregate
price level and quantity of aggregate output are determined in the
short run. It also provides a way to contrast how the economy
behaves in the long run and how it behaves in the short run.
Long Run
Short run

13. Aggregate Demand
Aggregate demand (AD) is the relationship between the quantity of output demanded and the aggregate price level. It tells us the quantity of goods and services people want to buy at any given level of prices. Recall the Quantity Theory of Money (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. It makes the not quite realistic, but very convenient assumption that velocity is constant over time. Also, when
interpreting this equation, 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. This equation states that supply of money balances M/P is equal to the demand and that demand is proportional to output.
The assumption of constant velocity is equivalent to the assumption of
a constant demand for real money balances per unit of output.

14. The Aggregate Demand Curve
The Aggregate Demand (AD) curve shows the negative relationship between the price level P and 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.
As the price level decreases, we’d
move down along the AD curve.
Price level
Any changes in M or V would shift
the AD curve.
Remember that the demand for real
output varies inversely with the price
level. AD
Y = MV/P
Output (Y)

15. Why the aggregate demand curve slopes downward
Think 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.

16. More about 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.
Let’s see how.

17. Shifts in Aggregate DemandAD
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 AD
curve inward from AD to AD'.
Price level
Output (Y)
AD'

18. Shifts in Aggregate DemandAD
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 AD
curve outward from AD to AD'.
Price level
Output (Y)
AD'

19. Aggregate Supply
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.
There are two different aggregate supply curves: the long-run aggregate
supply curve (LRAS) and the short-run aggregate supply curve (SRAS).
We also must discuss how the economy makes the transition from the
short run to the long run.
But, first, let’s build the long-run aggregate supply curve (LRAS).

20. The Vertical-Aggregate Supply Curve
The Long Run:
The Vertical-Aggregate Supply Curve
Because the classical model describes how the economy behaves in the long run, we can derive the long-run aggregate supply curve from the
classical model.
Recall 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 the classical model, output does not depend on the price
level. Let’s think about this considering the market clearing process in
the labor market, the “L” component of the production function.

21. Market Clearing in the Labor Market
Let’s begin at full employment, n*, with a wage of W/P0.
Now let’s see how workers will respond when there
is a sudden increase in the price level.
At this new lower real wage,
workers will cut back on hours worked.
Real wage,
W/P ns
(Employees)
But, at the same
time, employers increase their demand
for workers. n *
W/P0
W/2P0 n
n
(Employers) nd
What will happen next?
Hours worked

22. Back to Equilibrium (n*)
So, right now the labor market is in “disequilibrium” where the quantity demanded exceeds the quantity supplied.
We’re now going to see how “flexible wages” will allow the labor market to come back to equilibrium, at full employment, n*.
To hire more workers, the employer must raise the real wage to 2W.
As a result of 2W,
more workers are
hired, and the labor market
can move...
W/P ns
(Employees)
Back to Equilibrium (n*)
2W/2P0
W/2P0 n
n
(Employers) nd n *
Hours worked

23. The mechanism we just went through will enable us
to build our long run aggregate supply curve.
LRAS P
The vertical line suggests that changes in the price level
will have no lasting impact on
full employment. Y Y
Y=F (K, L)

24. The vertical-aggregate supply curve satisfies the classical dichotomy,
because it implies that the level of output is independent of the money
supply. This long-run level of output, Y, is called the full-employment or
natural level of output. It is the level of output at which the economy’s
resources are fully employed, or more realistically, at which
unemployment is at its natural rate.
LRAS P
A reduction in the money supply shifts the aggregate demand curve downward from AD to AD'. Since the AS curve is vertical in the long run, the reduction in AD affects the price level, but not the level of output. A AD B
AD' Y Y

25. The Short-Run: The Horizontal Aggregate Supply Curve
Remember that the the vertical LRAS curve assumed that changes in the price level left no lasting impact on Y (because of the market-clearing process)--that will be the model for examining the long term. But we need a theory for the short run, defined as the interval of time during which markets are not fully cleared.
LRAS
A simple, but useful first approach is to assume short-run price rigidity meaning that the aggregate supply curve is flat. As AD shifts to AD we slide in an east-west direction to point B on the short run aggregate supply curve (SRAS).
Then, in the long run, we move from B to C (move up and along AD). P C B P0
SRAS A
AD AD Y Y
Y = F (K,L)

26. The Long-run Equilibrium
LRAS P
SRAS AD Y Y
Y = F (K,L)
In the long run, the economy finds itself at the intersection of the
long-run aggregate supply curve and aggregate demand curve. Because
prices have adjusted to this level, the SRAS crosses this point as well.

27. A Reduction in Aggregate Demand
LRAS P
SRAS B A AD C
AD' Y Y
The economy begins in long-run equilibrium at point A. Then, a
reduction in aggregate demand, perhaps caused by a decrease in the
money supply M, moves the economy from point A to point B, where
output is below its natural level. As prices fall, the economy recovers
from the recession, moving from point B to point C.

28. Stabilization Policy
Exogenous changes in aggregate supply or aggregate demand are
called shocks. A shock that affects aggregate supply is called a
supply shock. A shock that affects aggregate demand is called
a demand shock. These shocks that disrupt the economy push output
and unemployment away from their natural levels.
A goal of the aggregate demand/aggregate supply model is to help
explain how shocks cause economic fluctuations. Economists use
the term stabilization policy to refer to the policy actions taken to
reduce the severity of short-run economic fluctuations. Stabilization
policy seeks to dampen the business cycle by keeping output and
employment as close to their natural rate as possible. The model in
this chapter is a simpler version of the one we’ll see in coming
chapters.

29. Shocks to Aggregate Demand
LRAS P C
SRAS B A
AD' AD Y Y
The economy begins in long-run equilibrium at point A. An increase
in aggregate demand, due to an increase in the velocity of money,
moves the economy from point A to point B, where output is above
its natural level. As prices rise, output gradually returns to its natural
rate, and the economy moves from point B to point C.

30. Shocks to Aggregate Supply
LRAS P B
SRAS'
SRAS A AD Y Y
An adverse supply shock pushes up costs and prices. If AD is held
constant, the economy moves from point A to point B, leading to
stagflation—a combination of increasing prices and declining level
of output. Eventually, as prices fall, the economy returns to the
natural rate at point A.

31. Accommodating an Adverse Supply Shock
LRAS P B
SRAS'
SRAS A
AD' AD Y Y
In response to an adverse supply shock, the Fed can increase aggregate
demand to prevent a reduction in output. The economy moves from
point A to point B. The cost of this policy is a permanently higher
level of prices.

32. Key Concepts of Chapter 9
Aggregate demand
Aggregate supply
Shocks
Demand shocks
Supply shocks
Stabilization policy