Worth: Mankiw Economics 5e HAPTER 9 Introduction to Economic Fluctuations 24 its real price by about 25 percent before it raises its nominal price. When inflation is 4 percent per year, the typical magazine changes its price about every six years Why do magazines keep their prices the same for so long? Economists do not have a definitive answer. The question is puzzling because it would seem that for magazines, the cost of a price change is small. To change prices, a mail-order firm must issue a new catalog and a restaurant must print a new menu, but a magazine publisher can simply print a new price on the cover of the next issue. Perhaps the cost to the publisher of charging the wrong price is also small. Or maybe cus tomers would find it inconvenient if the price of their favorite magazine As the magazine example shows, explaining at the microeconomic level why prices are sticky is sometimes hard. The cause of price stickiness is, therefore, an active area of research, which we discuss more fully in Chapter 19. In this chap ter, however, we simply assume that prices are sticky so we can start developing the link between sticky prices and the business cycle. Although not yet fully ex- plained, short-run price stickiness is widely believed to be crucial for under- standing short-run economic fuctuations The Model of Aggregate Supply and Aggregate Demand How does introducing sticky prices change our view of how the economy works We can answer this question by considering economists' two favorite words supply and demand. In classical macroeconomic theory, the amount of output depends on the conomy's ability to supply goods and services, which in turn depends on the supplies of capital and labor and on the available production technology. This is the essence of the basic classical model in Chapter 3, as well as of the Solow growth model in Chapters 7 and 8. Flexible prices are a crucial assumption of classical theory. The theory posits, sometimes implicitly, that prices adjust to en- sure that the ity of output demanded equals the quantity The economy works quite differently when prices are sticky. In this case, as we ill see, output also depends on the demand for goods and services Demand, in turn, is influenced by monetary policy, fiscal policy, and various other factors. Be cause monetary and fiscal policy can influence the economy's output over the time horizon when prices are sticky, price stickiness provides a rationale for why these policies may be useful in stabilizing the economy in the she ort run In the rest of this chapter, we develop a model that makes these ideas more pre- cise. The model of supply and demand, which we used in Chapter 1 to discuss the market for pizza, offers some of the most fundamental insights in economics.This model shows how the supply and demand for any good jointly determine the 2 Stephen G Cecchetti, "The Frequency of Price Adjustment: A Study of the Newsstand Prices of gazines, "Journal of Econometrics 31(1986): 255-274 User JoEkA: Job EFFo1425: 6264_ch09: Pg 241: 27133#/eps at 100+ wed,Feb13,200210:084
User JOEWA:Job EFF01425:6264_ch09:Pg 241:27133#/eps at 100% *27133* Wed, Feb 13, 2002 10:08 AM The Model of Aggregate Supply and Aggregate Demand How does introducing sticky prices change our view of how the economy works? We can answer this question by considering economists’ two favorite words— supply and demand. In classical macroeconomic theory, the amount of output depends on the economy’s ability to supply goods and services, which in turn depends on the supplies of capital and labor and on the available production technology.This is the essence of the basic classical model in Chapter 3, as well as of the Solow growth model in Chapters 7 and 8. Flexible prices are a crucial assumption of classical theory.The theory posits, sometimes implicitly, that prices adjust to ensure that the quantity of output demanded equals the quantity supplied. The economy works quite differently when prices are sticky. In this case, as we will see, output also depends on the demand for goods and services. Demand, in turn, is influenced by monetary policy, fiscal policy, and various other factors. Because monetary and fiscal policy can influence the economy’s output over the time horizon when prices are sticky, price stickiness provides a rationale for why these policies may be useful in stabilizing the economy in the short run. In the rest of this chapter,we develop a model that makes these ideas more precise.The model of supply and demand, which we used in Chapter 1 to discuss the market for pizza, offers some of the most fundamental insights in economics.This model shows how the supply and demand for any good jointly determine the CHAPTER 9 Introduction to Economic Fluctuations | 241 its real price by about 25 percent before it raises its nominal price.When inflation is 4 percent per year, the typical magazine changes its price about every six years.2 Why do magazines keep their prices the same for so long? Economists do not have a definitive answer.The question is puzzling because it would seem that for magazines, the cost of a price change is small.To change prices, a mail-order firm must issue a new catalog and a restaurant must print a new menu, but a magazine publisher can simply print a new price on the cover of the next issue. Perhaps the cost to the publisher of charging the wrong price is also small. Or maybe customers would find it inconvenient if the price of their favorite magazine changed every month. As the magazine example shows, explaining at the microeconomic level why prices are sticky is sometimes hard.The cause of price stickiness is, therefore, an active area of research, which we discuss more fully in Chapter 19. In this chapter, however, we simply assume that prices are sticky so we can start developing the link between sticky prices and the business cycle.Although not yet fully explained, short-run price stickiness is widely believed to be crucial for understanding short-run economic fluctuations. 2 Stephen G. Cecchetti,“The Frequency of Price Adjustment:A Study of the Newsstand Prices of Magazines,’’ Journal of Econometrics 31 (1986): 255–274
Worth: Mankiw Economics 5e 242 PART IV Business Cycle Theory: The Economy in the Short Run good's price and the quantity sold, and how shifts in supply and demand affect the price and quantity. In the rest of this chapter, we introduce the "economy-size version of this model-the model of aggregate supply and aggregate demand. 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. Although the model of aggregate supply and aggregate demand resembles the model of supply and demand for a single good, the analogy is not exact. The model of supply and demand for a single good considers only one good within a large economy. By contrast, as we will see in the coming chapters, the model of aggregate supply and aggregate demand is a sophisticated model that incorpo- rates the interactions among many markets. 9-2 Aggregate Demand Aggregate demand (AD)is the relationship between the quantity of output demanded and the aggregate price level. In other words, the aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices. We examine the theory of aggregate demand in detail in Chapters 10 through 12. Here we use the quantity theory of money to provide a simple, although incomplete, derivation of the aggregate demand curve. The Quantity Equation as Aggregate Demand Recall from Chapter 4 that the quantity theory says that 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. If the velocity of money is constant, then this equa You might recall that the quantity equation can be rewritten in terms of the pply and demand for real money balances M/P=(M/p)=kY where k= 1/V is a parameter determining how much money people want to hold for every dollar of income. In this form, the quantity equation states that the supply of real money balances M/P equals the demand (M/p)and that the de- mand is proportional to output Y. The velocity of money V is the "flip side" of the money demand parameter k For any fixed money supply and velocity, the quantity equation yields a nega- tive relationship between the price level P and output Y. Figure 9-2 graphs the combinations of P and Y that satisfy the quantity equation holding M and V constant.This downward-sloping curve is called the aggregate demand curve User JOENA: Job EFFo1425: 6264_ch09: Pg 242: 27134#/eps at 100*ml Wea,Feb13,200210:08AM
User JOEWA:Job EFF01425:6264_ch09:Pg 242:27134#/eps at 100% *27134* Wed, Feb 13, 2002 10:08 AM good’s price and the quantity sold, and how shifts in supply and demand affect the price and quantity. In the rest of this chapter, we introduce the “economy-size’’ version of this model—the model of aggregate supply and aggregate demand. 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. Although the model of aggregate supply and aggregate demand resembles the model of supply and demand for a single good, the analogy is not exact. The model of supply and demand for a single good considers only one good within a large economy. By contrast, as we will see in the coming chapters, the model of aggregate supply and aggregate demand is a sophisticated model that incorporates the interactions among many markets. 9-2 Aggregate Demand Aggregate demand (AD) is the relationship between the quantity of output demanded and the aggregate price level. In other words, the aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices.We examine the theory of aggregate demand in detail in Chapters 10 through 12. Here we use the quantity theory of money to provide a simple, although incomplete, derivation of the aggregate demand curve. The Quantity Equation as Aggregate Demand Recall from Chapter 4 that the quantity theory says that 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. If the velocity of money is constant, then this equation states that the money supply determines the nominal value of output, which in turn is the product of the price level and the amount of output. You might 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. In this form, the quantity equation states that the supply of real money balances M/P equals the demand (M/P) d and that the demand is proportional to output Y.The velocity of money V is the “flip side” of the money demand parameter k. For any fixed money supply and velocity, the quantity equation yields a negative relationship between the price level P and output Y. Figure 9-2 graphs the combinations of P and Y that satisfy the quantity equation holding M and V constant.This downward-sloping curve is called the aggregate demand curve. 242 | PART IV Business Cycle Theory: The Economy in the Short Run