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 9–1.
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.
77
AD
Y
Income, output
P
Pricelevel
Figure 9–1
C H A P T E R 9 Introduction to Economic Fluctuations
4. If the Fed increases the money supply, then the aggregate demand curve shifts outward,
as in Figure 9–2. 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 9–3.
Output increases in the short run to Y2. In the long run output returns to the natural-
78 Answers to Textbook Questions and Problems
P
Pricelevel
LRAS
C
A
B
SRAS
AD
AD
Y
Income, output
P2
P1
Y2Y
AD1
AD2
Figure 9–2
SRAS
B
Y
Income, output
A
C
LRASP
Pricelevel
Y2
Y
AD2
AD1
P2
P1
Figure 9–3
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 9–4, 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
Chapter 9 Introduction to Economic Fluctuations 79
LRASP
Pricelevel
B
A
AD
Y
Income, output
P2
P1
SRAS2
SRAS1
YY2
Figure 9–4
LRASP
Pricelevel
C
A
YY
Income, output
P2
P1
AD1
AD2
SRAS1
SRAS2
Figure 9–5
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 9–5.
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 9–6. 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.
80 Answers to Textbook Questions and Problems
LRASP
Pricelevel
B A
C
Y
P1
P2
Y2
Y
AD1
AD2
SRAS
Income, output
Figure 9–6
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 9–7.
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 9–8. 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.
Chapter 9 Introduction to Economic Fluctuations 81
SRAS
YY
Income, output
A
LRASP
Pricelevel
AD2
AD1
Figure 9–7
LRAS
SRAS
Y
Income, output
P
P
Pricelevel
Y
AD2
AD1
Figure 9–8
b. In the short run, we assume that the price level is fixed and that the aggregate
supply curve is flat. As Figure 9–9 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 4 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 9–9.
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 9–9.
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,
82 Answers to Textbook Questions and Problems
SRAS
B A
C
P
LRAS
Y
5%
Pricelevel
Y
5%
Income, output
Y
P1
P2
Y2
AD2
AD1
P
Y
Figure 9–9
Chapter 9 Introduction to Economic Fluctuations 83
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 9–10 shows that this causes the real interest rate to rise. When Y
returns to its original equilibrium level, so does the real interest rate.
I, S
Investment, Saving
Realinterestrate
r
I(r)
r1
r2
S2
S1 Figure 9–10
3. a. An exogenous decrease in the velocity of money causes the aggregate demand
curve to shift downward, as in Figure 9–11. 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 9–11. Therefore, it should
increase the money supply and shift the aggregate demand curve upward, again
restoring the original equilibrium at point A.
Thus, both Feds make 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 9–12.
YY
Income, output
Pricelevel
P LRAS
C
B
A
P2
P1
SRAS2
SRAS1
AD2
AD1
Figure 9–12
84 Answers to Textbook Questions and Problems
P1
P2 AD1
AD2
Y
LRASP
Pricelevel
B A
C
SRAS
Y
Income, output
Figure 9–11
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 9–12. 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, the two Feds make a different policy choice in response to a supply
shock.
4. From the main NBER web page (www.nber.org), I followed the link to Business
Cycle Dates (downloaded February 19, 2009). As of this writing, the latest turning
point was in December 2007, when the economy switched from expansion to contraction.
As of this writing, the recession is still ongoing.
Previous recessions (contractions) over the past three decades were 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.
Chapter 9 Introduction to Economic Fluctuations 85