Worth: Mankiw Economics 5e User JoENA: Job EFFo1425: 6264_ch09: Pg 236: 24782#/eps at 100s wed,Feb13,200210:074
User JOEWA:Job EFF01425:6264_ch09:Pg 236:24782#/eps at 100% *24782* Wed, Feb 13, 2002 10:07 AM
Worth: Mankiw Economics 5e part IV Business Cycle Theory The Economy in the short run User JoENA: Job EFFo1425: 6264_ch09: Pg 237: 27129 #/eps at 100s wed,Feb13,200210:07
User JOEWA:Job EFF01425:6264_ch09:Pg 237:27129#/eps at 100% *27129* Wed, Feb 13, 2002 10:07 AM part IV Business Cycle Theory: The Economy in the Short Run
Worth: Mankiw Economics 5e CHAPTER NINE Introduction to Economic fluctuations The modern world regards business cycles much as the ancient egyptian regarded the overflowing of the Nile. The phenomenon recurs at intervals, it is of great importance to everyone, and natural causes of it are not in sight John Bates Clark, 1898 Economic fluctuations present a recurring problem for economists and policy makers. This problem is illustrated in Figure 9-1, which shows growth in real GDP for the U.S. 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. Recessions--periods of falling incomes and rising unemployment-are frequent. 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 reces- sions, 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. When recessions end and the economy enters a boom, these effects work in reverse: incomes rise, unemploy ment falls, and workweeks expand Economists call these short-run fluctuations in output and employment the business cycle. 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 Ill of this book, we developed theories to explain how the economy behaves in the long run. Those theories were based on the classical dichotomy-the premise that real variables, such as output and employment,are not affected by what happens to nominal variables, such as the money supply and the price level. Although classical theories are useful for explaining long-run trends, including the economic growth we observe from decade to decade, most economists believe that the classical dichotomy does not hold in the short run d, therefore, that classical theories cannot explain year-to-year fluctuations output and employment. Here, in Part IV, we see how economists explain these short-run fluctuation 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 supply 238 User JOENA: Job EFFo1425: 6264_ch09: Pg 238: 27130#/eps at 100*mg wea,Feb13,200210:07AM
User JOEWA:Job EFF01425:6264_ch09:Pg 238:27130#/eps at 100% *27130* Wed, Feb 13, 2002 10:07 AM Economic fluctuations present a recurring problem for economists and policymakers. This problem is illustrated in Figure 9-1, which shows growth in real GDP for the U.S. 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. Recessions—periods of falling incomes and rising unemployment—are frequent. 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.When recessions end and the economy enters a boom, these effects work in reverse: incomes rise, unemployment falls, and workweeks expand. Economists call these short-run fluctuations in output and employment the business cycle. 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. Those theories were based on the classical dichotomy—the premise that real variables, such as output and employment, are not affected by what happens to nominal variables, such as the money supply and the price level. Although classical theories are useful for explaining long-run trends, including the economic growth we observe from decade to decade, most economists believe that the classical dichotomy does not hold in the short run and, therefore, that classical theories cannot explain year-to-year fluctuations in output and employment. 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 supply Introduction to Economic Fluctuations 9 CHAPTER The modern world regards business cycles much as the ancient Egyptians regarded the overflowing of the Nile.The phenomenon recurs at intervals, it is of great importance to everyone, and natural causes of it are not in sight. — John Bates Clark, 1898 NINE 238 |
Worth: Mankiw Economics 5e HAPTER 9 Introduction to Economic Fluctuations 239 Real GDP growth rate Average growth rate 1960 1970 1975 1980 1985 1995 2000 Real GDP Growth in the United States Growth in real GDP averages about 3. 5 percent per year, as indicated by the orange line, but there are substantial fluctuations around this average Recessions are periods when the production of goods and services is declining, represented here by negative growth in real GDP Source: U.S. Department of Commerce. and aggregate demand. With this model we can show how shocks to the econ- omy lead to short-run fuctuations 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 eco- nomic policies. The model we develop over the next several chapters shows how monetary and fiscal policies infuence 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 w 9-1 Time Horizons in macroeconomics Before we start building a model of short-run economic fluctuations, let's step back and ask a fundamental question: Why do economists need different models or different time horizons? Why can, t we stop the course here and be content with the classical models developed in Chapters 3 through 8? The answer, as this book has consistently reminded its reader, is that classical macroeconomic theory applies to the long run but not to the short run. But why is this so? User JOENA: Job EFFo1425: 6264_ch09: Pg 239: 27131#eps at 100*gl wed,Feb13,200210:074
User JOEWA:Job EFF01425:6264_ch09:Pg 239:27131#/eps at 100% *27131* Wed, Feb 13, 2002 10:07 AM and 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. 9-1 Time Horizons in Macroeconomics Before we start building a model of short-run economic fluctuations, let’s step back and ask a fundamental question:Why do economists need different models for different time horizons? Why can’t we stop the course here and be content with the classical models developed in Chapters 3 through 8? The answer, as this book has consistently reminded its reader, is that classical macroeconomic theory applies to the long run but not to the short run. But why is this so? CHAPTER 9 Introduction to Economic Fluctuations | 239 figure 9-1 Percentage change from 4 quarters earlier 10 8 6 4 2 0 2 4 1960 1965 Year 1970 1975 1980 1985 1990 1995 2000 Real GDP growth rate Average growth rate Real GDP Growth in the United States Growth in real GDP averages about 3.5 percent per year, as indicated by the orange line, but there are substantial fluctuations around this average. Recessions are periods when the production of goods and services is declining, represented here by negative growth in real GDP. Source: U.S. Department of Commerce
Worth: Mankiw Economics 5e 240 PART IV Business Cycle Theory: The Economy in the Short Run How the Short Run and Long Run Differ Most macroeconomists believe that the key difference between the short run and the long run is the behavior of prices. In the long run, prices are flexible and can re- spond 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. To see how the short run and the long run differ, consider the effects of a hange in monetary policy. Suppose that the Federal Reserve suddenly reduced the money supply by 5 percent. According to the classical model, which almost all economists agree describes the economy in the long run, the money supply affects nominal variables--variables measured in terms of money-but not real ariables. In the long run, a 5-percent reduction in the money supply lowers all prices(including nominal wages) by 5 percent whereas all real variables remain the same. Thus, in the long run, changes in the money supply do not cause fuc tuations in output or employme ent In the short run, however, many prices do not respond to changes in mone ary 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 Instead, there is little immediate change in many prices; that is, many prices are sticky. This short-run price stickiness implies that the short-run impact of change in the money supply is not the same as the lor ing-run impact A model of economic fluctuations must take into account this short-run price ickiness. 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 instead. In other words, during the time horizon over which prices are classical dichotomy no longer holds: nominal variables can influence real and the economy can deviate from the equilibrium predicted by the classical model CASE STUDY The Puzzle of Sticky Magazine Prices How sticky are prices? The answer to this question depends on what price we consider Some commodities, such as wheat, soybeans, and pork bellies, are traded on organized exchanges, and their prices change every minute. No one would call these prices sticky. Yet the prices of most goods and services change much less frequently. One survey found that 39 percent of firms change their price once a year, and another 10 percent change their prices less than once a year. The reasons for price stickiness are not always apparent. Consider, for example, the market for magazines. A study has documented that magazines change their ewsstand prices very infrequently. The typical magazine allows infation to erode I Alan S Blinder, On Sticky Prices: Academic Theories Meet the Real World, "in N.G. Mankiw ed, Monetary Policy(Chicago: University of Chicago Press, 1994): 117-154 A case study in Chap. ter 19 discusses this survey in more detail. User JOENA: Job EFFo1425: 6264_ch09: Pg 240: 27132#eps at 100*mm Wea,Feb13,200210:08AM
User JOEWA:Job EFF01425:6264_ch09:Pg 240:27132#/eps at 100% *27132* Wed, Feb 13, 2002 10:08 AM How the Short Run and Long Run Differ Most macroeconomists believe that the key difference between the short run and the long run is the behavior 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. 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. According to the classical model, which almost all economists agree describes the economy in the long run, the money supply affects nominal variables—variables measured in terms of money—but not real variables. In the long run, a 5-percent reduction in the money supply lowers all prices (including nominal wages) 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. Instead, there is little immediate change in many prices; that is, many prices are sticky. This short-run price stickiness implies that the short-run impact of a change in the money supply is not the same as the long-run impact. 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. In other words, during the time horizon over which prices are sticky, the classical dichotomy no longer holds: nominal variables can influence real variables, and the economy can deviate from the equilibrium predicted by the classical model. 240 | PART IV Business Cycle Theory: The Economy in the Short Run CASE STUDY The Puzzle of Sticky Magazine Prices How sticky are prices? The answer to this question depends on what price we consider. Some commodities, such as wheat, soybeans, and pork bellies, are traded on organized exchanges, and their prices change every minute. No one would call these prices sticky.Yet the prices of most goods and services change much less frequently. One survey found that 39 percent of firms change their prices once a year, and another 10 percent change their prices less than once a year.1 The reasons for price stickiness are not always apparent. Consider, for example, the market for magazines. A study has documented that magazines change their newsstand prices very infrequently. The typical magazine allows inflation to erode 1 Alan S. Blinder,“On Sticky Prices:Academic Theories Meet the Real World,’’ in N. G. Mankiw, ed., Monetary Policy (Chicago: University of Chicago Press, 1994): 117–154.A case study in Chapter 19 discusses this survey in more detail