Macroeconomics

N. Gregory Mankiw

Introduction to
Economic
Fluctuations

Presentation Slides

© 2022 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 in the
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.”
3 The
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Introduction
Science
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of Macroeconomics
to Economic Fluctuations
Facts about the business cycle

• GDP growth averages 3 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
Growth rates of real GDP, consumption
Growth rates of real GDP, consumption, investment
Unemployment
Okun’s law
Index of leading economic indicators

• Published monthly by the Conference Board.

• Aims to forecast changes in economic activity six to nine
months into the future.
• Used in planning by businesses and government, despite
not being a perfect predictor.
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
• ISM new orders index
• New building permits issued
• Index of stock prices
• Lending credit index
• Yield spread (10 years minus 3 months) on Treasuries
• Index of consumer expectations
Time horizons in macroeconomics

• Long run
Prices are flexible, responding to changes in supply or
demand.
• Short run
Many prices are “sticky” at a predetermined level.

The economy behaves much

differently when prices are sticky.
Recap of classical macro theory (Chapters 3–10)

• Output is determined by the supply side:

• supplies of capital, labor
• technology
• Changes in demand for goods and services (C, I, G)
only affect prices, not quantities.
• Assumes complete price flexibility.
• Applies to the long run.
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
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 in the long run
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 11–13 develop the theory of aggregate demand
in more detail.
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 . . .
 The downward-sloping AD curve

An increase in
the price level
causes a fall in
real money
balances (M/P),
causing a
decrease in the
demand for
goods and
services.
 Shifting the AD curve

A reduction in the money supply shifts the aggregate

demand curve to the left.
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, at

which the economy’s resources are fully employed.

“Full employment” means that unemployment equals its

natural rate (not zero).
 The long-run aggregate supply curve

In the long run, output is

determined by the
amounts of capital and
labor and by the available
technology; it does not
depend on the price level.
Therefore, the long-run
aggregate supply (LRAS)
curve is vertical.
Long-run effects of a decrease in M (1 of 4)
Starting in the initial equilibrium
at A, M down shifts AD in. The
economy reaches a new
equilibrium B, with a lower price
level, and the same level of
output.
Long-run effects of a decrease in M (2 of 4)

Starting in the initial

equilibrium
Long-run effects of a decrease in M (3 of 4)

Then M down,
causes AD to shift in
Long-run effects of a decrease in M (4 of 4)

With a new equilibrium at B, which has a lower price

level, and the same level of output
Aggregate supply in the short run

• Many prices are sticky in the short run.

• For now (and through Chapter 13), 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.
 The short-run aggregate supply curve

The SRAS
curve is
horizontal:
The price level
is fixed at a
predetermined
level (), and
firms sell as
much as
buyers
demand.
 Short-run effects of a decrease in M (1 of 4)

Starting in initial
equilibrium at A, M
decreases. M
down causes AD
to shift in. The
inward shift
causes the
economy to move
to a new
equilibrium at B,
where output falls
and price level
remains the same.
 Short-run effects of a decrease in M (2 of 4)

Starting in initial
equilibrium at A
 Short-run effects of a decrease in M (3 of 4)

M down causes
AD to shift in.
 Short-run effects of a decrease in M (4 of 4)

The inward shift

in AD causes
the economy to
move to a new
equilibrium at
B, where output
falls and price
level remains
the same.
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 then over time,
equilibrium, if 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.
 The short- and long-run effects of a decrease in M
(1 of 5)

The inward shift

in AD causes
the economy to
move to a new
short-run
equilibrium at B,
and then prices
adjust and the
economy
reaches the
new long-run
equilibrium at C.
 The short- and long-run effects of a decrease in M
(2 of 5)

The initial equilibrium

 The short- and long-run effects of a decrease in M
(3 of 5)
The decrease
in M causes
AD to shift in.
 The short- and long-run effects of a decrease in M
(4 of 5)

Causing a new
short-run
equilibrium at
B. Price level
remains
unchanged, but
output falls.
 The short- and long-run effects of a decrease in M
(5 of 5)

In the long run,

prices adjust and
the economy
reaches a new
long-run
equilibrium at C.
Price level is
lower, and output
returns to Y .
How shocking!

• Shocks: exogenous changes in aggregate supply or

demand
• Shocks temporarily push the economy away from full
employment.
• For 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.
 The effects of a positive demand shock

A positive demand
shock shifts AD out to
AD2, and the economy
has a new short-run
equilibrium at B.

The economy self-

adjusts with increased
prices and causes the
economy to reach the
new long-run
equilibrium at C.
Supply shocks

• A supply shock alters production costs and affects the

prices that firms charge (also called price shocks).
• Examples of adverse supply shocks:
• Bad weather reduces crop yields, pushing up food
prices.
• Oil cartel raise the price of oil.
• Favorable supply shocks lower costs and prices.
CASE STUDY: The 1970s oil shocks, part 1

• Early 1970s: OPEC coordinated a reduction in the supply

of oil.
• Oil prices rose
11 percent in 1973
68 percent in 1974
16 percent in 1975
• Such sharp oil price increases are supply shocks
because they significantly impact production costs and
prices.
 CASE STUDY: The 1970s oil shocks, part 2 (1 of 4)

An increase in oil
prices causes SRAS
to shift up. This
causes a new short-
run equilibrium at B.
In the long run,
prices adjust and
cause SRAS to shift
down back to the
original position,
reaching a new
long-run equilibrium
at C (which is the
same as A)
 CASE STUDY: The 1970s oil shocks, part 2 (2 of 4)
The initial equilibrium
at A.
 CASE STUDY: The 1970s oil shocks, part 2 (3 of 4)

An increase in oil
prices causes
SRAS to shift up.
This causes a
new short-run
equilibrium at B.

Price level
increases and
output falls in the
short run.
 CASE STUDY: The 1970s oil shocks, part 2 (4 of 4)

In the long run,

prices adjust and
cause SRAS to shift
down back to the
original position,
reaching a new long-
run equilibrium at C
(which is the same
as A).
 CASE STUDY: The 1970s oil shocks, part 3

Predicted effects
of the oil shock:
• inflation rate up
• output down
• unemployment
up
…and then a
gradual recovery
 CASE STUDY: The 1970s oil shocks, part 4

Late 1970s: As
the economy
was recovering,
oil prices shot
up again,
causing another
huge supply
shock!
 CASE STUDY: The 1980s oil shocks

1980s: A
favorable supply
shock—a
significant fall in
oil prices
As the model
predicts, inflation
and
unemployment
fell.
Stabilization policy

Stabilization policy: policy actions aimed at reducing the

severity of short-run economic fluctuations.
For example: using monetary policy to combat the effects of
adverse supply shocks
 Stabilizing output with monetary policy, part 1 (1 of 4)

A negative supply shock

shifts SRAS up. Without
intervention from the
Central Bank, the
economy would reach a
new equilibrium at B.
However, the Central
Bank responds by
increasing the money
supply, shifting AD out,
resulting in a new
equilibrium at C (with
higher price level, and no
reduction in output).
 Stabilizing output with monetary policy, part 1 (2 of 4)

Initial
equilibrium
(before the
negative
supply shock)
 Stabilizing output with monetary policy, part 1 (3 of 4)

A negative supply
shock shifts SRAS up.
Without intervention
from the Central
Bank, the economy
would reach a new
equilibrium at B. Price
level would be higher
and output would be
lower.

However, the Central

Bank will attempt to
stabilize output.
 Stabilizing output with monetary policy, part 1 (4 of 4)

However, the Central

Bank responds by
increasing the money
supply, shifting AD out,
resulting in a new
equilibrium at C (with
higher price level and
no reduction in output).
The economy instead
ends up at C, instead
of B, due to the
stabilization policy.
The Covid-19 Recession

• Initially, the shock to the economy was an inward in

LRAS.
• Businesses closed
• Businesses that remained open saw decreased
productivity because of social distancing.
• However, as businesses closed, consumers lost the
ability to spend money, AD shifted in due to C down.
• Unable to dine-in at restaurants
• Unable to travel
• Unable to attend concerts, movies, sporting events,
museums, etc.
• Ending the recession is foremost a public health issue,
not an economics issue.
 C H A P T E R S U M M A R Y, P A R T 1
• Long run: Prices are flexible, output and
employment are always at their natural rates, and
the classical theory applies.
Short run: Prices are sticky, and shocks can push
output and employment away from their natural
rates.
• Aggregate demand and supply: a framework to
analyze economic fluctuations

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 C H A P T E R S U M M A R Y, P A R T 2
• The aggregate demand curve slopes downward.
• The long-run aggregate supply curve is vertical
because output depends on technology and factor
supplies but not prices.
• The short-run aggregate supply curve is horizontal
because prices are sticky at predetermined levels.

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 C H A P T E R S U M M A R Y, P A R T 3
• Shocks to aggregate demand and supply cause
fluctuations in GDP and employment in the short
run.
• The Fed can attempt to stabilize the economy with
monetary policy.

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Introduction
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of Macroeconomics
to Economic Fluctuations