Answers to Textbook Questions and Problems CHAPTER 10 Introduction to Economic Fluctuations Questions for Review 1. When GDP declines during a recession, growth in real consumption and investment spending both decline; unemployment rises sharply. 2. The price of a magazine is an example of a price that is sticky in the short run and flexible in the long run. Economists do not have a definitive answer as to why magazine prices are sticky in the short run. Perhaps customers would find it inconvenient if the price of a magazine they purchase changed every month. 3. Aggregate demand is the relation between the quantity of output demanded and the aggregate price level. To understand why the aggregate demand curve slopes downward, we need to develop a theory of aggregate demand. One simple theory of aggregate demand is based on the quantity theory of money. Write the quantity equation in terms of the supply and demand for real money balances as M/P = (M/P)d = kY, where k = 1/V. This equation tells us that for any fixed money supply M, a negative relationship exists between the price level P and output Y, assuming that velocity V is fixed: the higher the price level, the lower the level of real balances and, therefore, the lower the quantity of goods and services demanded Y. In other words, the aggregate demand curve slopes downward, as in Figure 10-1. One way to understand this negative relationship between the price level and output is to note the link between money and transactions. If we assume that V is constant, then the money supply determines the dollar value of all transactions: MV = PY. An increase in the price level implies that each transaction requires more dollars. For the above identity to hold with constant velocity, the quantity of transactions and thus the quantity of goods and services purchased Y must fall. 4. If the Fed increases the money supply, then the aggregate demand curve shifts outward, as in Figure 10-2. In the short run, prices are sticky, so the economy moves along the short-run aggregate supply curve from point A to point B. Output rises above its natural rate level Y : the economy is in a boom. The high demand, however, eventually causes wages and prices to increase. This gradual increase in prices moves the economy along the new aggregate demand curve AD2 to point C. At the new long-run equilibrium, output is at its natural-rate level, but prices are higher than they were in the initial equilibrium at point A. 5. It is easier for the Fed to deal with demand shocks than with supply shocks because the Fed can reduce or even eliminate the impact of demand shocks on output by controlling the money supply. In the case of a supply shock, however, there is no way for the Fed to adjust aggregate demand to maintain both full employment and a stable price level. To understand why this is true, consider the policy options available to the Fed in each case. Suppose that a demand shock (such as the introduction of automatic teller machines, which reduces money demand by decreasing the parameter k and therefore increasing velocity V) shifts the aggregate demand curve outward, as in Figure 10-3. Output increases in the short run to Y2. In the long run, output returns to the natural-rate level, but at a higher price level P2. The Fed can offset this increase in velocity, however, by reducing the money supply; this returns the aggregate demand curve to its initial position, AD1. To the extent that the Fed can control the money supply, it can reduce or even eliminate the impact of demand shocks on output. Now consider how an adverse supply shock (such as a crop failure or an increase in union aggressiveness) affects the economy. As shown in Figure 10-4, the short-run aggregate supply curve shifts up, and the economy moves from point A to point B. Output falls below the natural rate, and prices rise. The Fed has two options. Its first option is to hold aggregate demand constant, in which case output falls below its natural rate. Eventually prices fall and restore full employment, but the cost is a painful recession. Its second option is to increase aggregate demand by increasing the money supply, bringing the economy back toward the natural rate of output, as in Figure 10-5. This policy leads to a permanently higher price level at the new equilibrium, point C. Thus, in the case of a supply shock, there is no way to adjust aggregate demand to maintain both full employment and a stable price level. Problems and Applications 1. a. Interest-bearing checking accounts make holding money more attractive. This increases the demand for money. b. The increase in money demand is equivalent to a decrease in the velocity of money. Recall the quantity equation M/P = kY, where k = 1/V. For this equation to hold, an increase in real money balances for a given amount of output means that k must increase; that is, velocity falls. Because interest on checking accounts encourages people to hold money, dollars circulate less frequently. c. If the Fed keeps the money supply the same, the decrease in velocity shifts the aggregate demand curve downward, as in Figure 10-6. In the short run when prices are sticky, the economy moves from the initial equilibrium, point A, to the short-run equilibrium, point B. The drop in aggregate demand reduces the output of the economy below the natural rate. Over time, the low level of aggregate demand causes prices and wages to fall. As prices fall, output gradually rises until it reaches the natural-rate level of output at point C. d. The decrease in velocity causes the aggregate demand curve to shift downward. The Fed could increase the money supply to offset this decrease and thereby return the economy to its original equilibrium at point A, as in Figure 10-7. To the extent that the Fed can accurately measure changes in velocity, it has the ability to reduce or even eliminate the impact of such a demand shock on output. In particular, when a regulatory change causes money demand to change in a predictable way, the Fed should make the money supply respond to that change in order to prevent it from disrupting the economy. e. The decrease in velocity shifts the aggregate demand curve down and to the left. In the short run, the price level remains the same and the level of output falls below the natural rate. If the Fed wants to stabilize output and return it to the natural rate, they should increase the money supply. Note that increasing the money supply in this case will stabilize both output and the price level so that the answer here is the same as in part (d). 2. a. If the Fed reduces the money supply, then the aggregate demand curve shifts down, as in Figure 10-8. This result is based on the quantity equation MV = PY, which tells us that a decrease in money M leads to a proportionate decrease in nominal output PY (assuming that velocity V is fixed). For any given price level P, the level of output Y is lower, and for any given Y, P is lower. b. In the short run, we assume that the price level is fixed and that the aggregate supply curve is flat. As Figure 10-9 shows, in the short run, the leftward shift in the aggregate demand curve leads to a movement from point A to point B—output falls but the price level doesn’t change. In the long run, prices are flexible. As prices fall, the economy returns to full employment at point C. If we assume that velocity is constant, we can quantify the effect of the 5-percent reduction in the money supply. Recall from Chapter 5 that we can express the quantity equation in terms of percentage changes: %Δ in M + %Δ in V = %Δ in P + %Δ in Y. If we assume that velocity is constant, then the %Δ in V = 0. Therefore, %Δ in M = %Δ in P + %Δ in Y. We know that in the short run, the price level is fixed. This implies that the %Δ in P = 0. Therefore, %Δ in M = %Δ in Y. Based on this equation, we conclude that in the short run a 5-percent reduction in the money supply leads to a 5-percent reduction in output. This is shown in Figure 10-9. In the long run, we know that prices are flexible and the economy returns to its natural rate of output. This implies that in the long run, the %Δ in Y = 0. Therefore, %Δ in M = %Δ in P. Based on this equation, we conclude that in the long run a 5-percent reduction in the money supply leads to a 5-percent reduction in the price level, as shown in Figure 10-9. c. Okun’s law refers to the negative relationship that exists between unemployment and real GDP. Okun’s law can be summarized by the equation %Δ in Real GDP = 3% – 2 [Δ in Unemployment Rate]. That is, output moves in the opposite direction from unemployment, with a ratio of 2 to 1. In the short run, when output falls, unemployment rises. Quantitatively, if velocity is constant, we found that output falls 5 percentage points relative to full employment in the short run. Okun’s law states that output growth equals the full employment growth rate of 3 percent minus two times the change in the unemployment rate. Therefore, if output falls 5 percentage points relative to fullemployment growth, then actual output growth is –2 percent. Using Okun’s law, we find that the change in the unemployment rate equals 2.5 percentage points: –2 = 3 – 2 [Δ in Unemployment Rate] [–2 – 3]/[–2] = [Δ in Unemployment Rate] 2.5 = [Δ in Unemployment Rate]. In the long run, both output and unemployment return to their natural rate levels. Thus, there is no long-run change in unemployment. d. The national income accounts identity tells us that saving S = Y – C – G. Thus, when Y falls, S falls (assuming the marginal propensity to consume is less than one). Figure 10-10 shows that this causes the real interest rate to rise. When Y returns to its original equilibrium level, so does the real interest rate. 3. a. An exogenous decrease in the velocity of money causes the aggregate demand curve to shift downward, as in Figure 10-11. In the short run, prices are fixed, so output falls. If the Fed wants to keep output and employment at their natural-rate levels, it must increase aggregate demand to offset the decrease in velocity. By increasing the money supply, the Fed can shift the aggregate demand curve upward, restoring the economy to its original equilibrium at point A. Both the price level and output remain constant. If the Fed wants to keep prices stable, then it wants to avoid the long-run adjustment to a lower price level at point C in Figure 10-11. Therefore, it should increase the money supply and shift the aggregate demand curve upward, again restoring the original equilibrium at point A. Thus, for both scenarios, the Fed makes the same choice of policy in response to this demand shock. b. An exogenous increase in the price of oil is an adverse supply shock that causes the short-run aggregate supply curve to shift upward, as in Figure 10-12. If the Fed cares about keeping output and employment at their natural-rate levels, then it should increase aggregate demand by increasing the money supply. This policy response shifts the aggregate demand curve upwards, as shown in the shift from AD1 to AD2 in Figure 10-12. In this case, the economy immediately reaches a new equilibrium at point C. The price level at point C is permanently higher, but there is no loss in output associated with the adverse supply shock. If the Fed cares about keeping prices stable, then there is no policy response it can implement. In the short run, the price level stays at the higher level P2. If the Fed increases aggregate demand, then the economy ends up with a permanently higher price level. Hence, the Fed must simply wait, holding aggregate demand constant. Eventually, prices fall to restore full employment at the old price level P1. But the cost of this process is a prolonged recession. Thus, for both scenarios, the Fed makes a different policy choice in response to a supply shock. 4. The last turning point was in June 2009—from recession to recover/expansion. Previous recessions (contractions) over the past three decades were December 2007 to June 2009, March 2001 to November 2001, July 1990 to March 1991, July 1981 to November 1982, January 1980 to July 1980, and November 1973 to March 1975. 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 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.” 1 Facts about the business cycle ▪ GDP growth averages 3–3.5 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. CHAPTER 10 Introduction to Economic Fluctuations 2 Index of Leading Economic Indicators ▪ Published monthly by the Conference Board. ▪ Aims to forecast changes in economic activity 6-9 months into the future. ▪ Used in planning by businesses and govt, despite not being a perfect predictor. CHAPTER 10 Introduction to Economic Fluctuations 7 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 ▪Vendor performance ▪New building permits issued ▪Index of stock prices ▪M2 ▪Yield spread (10-year minus 3-month) on Treasuries ▪Index of consumer expectations Time horizons in macroeconomics ▪ Long run Prices are flexible, respond 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 (Chaps. 3-9) ▪Output is determined by the supply side: ▪supplies of capital, labor ▪technology ▪ Changes in demand for goods & 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 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 10–12 develop the theory of aggregate demand in more detail. The Quantity Equation as Aggregate Demand ▪From Chapter 4, recall the quantity equation M V = P Y ▪For given values of M and V, this equation implies an inverse relationship between P and Y … The downward-sloping AD curve Shifting the AD curve P An increase in the money supply shifts the AD curve to the right. Aggregate supply in the long run ▪Recall from Chap. 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 Y does not depend on P, so LRAS is vertical. Long-run effects of an increase in M Aggregate supply in the short run ▪ Many prices are sticky in the short run. ▪ For now (and through Chap. 12), 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 Short-run effects of an increase in M 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 equilibrium, if then over time, 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 SR & LR effects of ΔM > 0 A = initial equilibrium B = new shortrun eq’m after Fed increases M C = long-run equilibrium How shocking!!! ▪shocks: exogenous changes in agg. supply or demand ▪Shocks temporarily push the economy away from full employment. ▪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 negative demand shock Supply shocks ▪A supply shock alters production costs, affects the prices that firms charge. (also called price shocks) ▪ Examples of adverse supply shocks: ▪ Bad weather reduces crop yields, pushing up food prices. ▪ Workers unionize, negotiate wage increases. ▪ New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance. ▪ Favorable supply shocks lower costs and prices. CASE STUDY: The 1970s oil shocks ▪ Early 1970s: OPEC coordinates a reduction in the supply of oil. ▪ Oil prices rose 11% in 1973 68% in 1974 16% in 1975 ▪ Such sharp oil price increases are supply shocks because they significantly impact production costs and prices. CASE STUDY: The 1970s oil shocks Stabilization policy ▪ def: policy actions aimed at reducing the severity of short-run economic fluctuations. ▪ Example: Using monetary policy to combat the effects of adverse supply shocks…Stabilizing output with monetary policy P LRAS The adverse supply shock moves the economy to point B. Stabilizing output with monetary policy 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, shocks can push output and employment away from their natural rates. 2. Aggregate demand and supply: a framework to analyze economic fluctuations 3. The aggregate demand curve slopes downward. 4. The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices. 5. The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels. 6. Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run. 7. The Fed can attempt to stabilize the economy with monetary policy. Solution Manual for Macroeconomics Gregory N. Mankiw 9781464182891, 9781319106058
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