Summary Ch.9 Mankiw

Summary Chapter 9 Introduction to Economic Fluctuations
Economic fluctuations present a recurring problem for economists and policymakers.

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. 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. 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. 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 supplyand 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.
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. In the long run, a 5-percent
reduction in the money supply lowers all prices 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. 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. 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. The model of supply and demand for a single good
considers only one good within a large economy.
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.
Curve Changes in the money supply shift the aggregate demand curve. In panel , a
decrease in the money supply M reduces the nominal value of output PY. In panel , an increase
in the money supply M raises the nominal value of output PY. 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.
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. 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 . 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.
The classical model and the vertical aggregate supply curve apply only in the long run.
Because of this price stickiness, the short-run aggregate supply curve is not vertical. Demand
curve and this horizontal short-run aggregate supply curve. For example, if the Fed suddenly
reduces the money supply, the aggregate demand curve shifts inward.
Fluctuations in the economy as a whole come from changes in aggregate supply or

aggregate demand. Economists call exogenous changes in these curves shocks to the economy.
One goal of the model of aggregate supply and aggregate demand is to show how shocks cause
economic fluctuations. Another goal of the model is to evaluate how macroeconomic policy can
respond to these shocks. Because output and employment fluctuate around their long-run
natural rates, stabilization policy dampens the business cycle by keeping output and
employment as close to their natural rates as possible.
Credit cards are often a more convenient way to make purchases than using cash, they
reduce the quantity of money that people choose to hold. Because of this increase in the
money supply, the price level approximately doubled during the war. The Greenback party was
formed with the primary goal of maintaining the system of fiat money. When each person holds
less money, the money demand parameter k falls. This means that each dollar of money moves
from hand to hand more quickly, so velocity V rises.
As the price level rises, the quantity of output demanded declines, and the economy
gradually approaches the natural rate of production. But during the transition to the higher
price level, the economy’s output is higher than the natural rate.
Shocks to aggregate supply, as well as shocks to aggregate demand, can cause economic
fluctuations. A supply shock is a shock to the economy that alters the cost of producing goods
and services and, as a result, the prices that firms charge. Firms pass on the added costs to
customers in the form of higher prices. An increase in union aggressiveness.This pushes up
wages and the prices of the goods produced by union workers. All these events are adverse
supply shocks, which means they push costs and prices upward.A favorable supply shock, such
as the breakup of an international oil cartel, reduces costs and prices. Figure 9-11 shows how
an adverse supply shock affects the economy.

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Summary Chapter 9 Introduction to Economic Fluctuations

Economic fluctuations present a recurring problem for economists and policymakers.

Fluctuations in the economy as a whole come from changes in aggregate supply or

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