9Chapter-Mankiw - CHAPTER 9 Introduction to Economic...

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Questions for Review 1. The price of a magazine is an example of a price that is sticky in the short run and flex- ible 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. 2. Aggregate demand is the relation between the quantity of output demanded and the aggregate price level. To understand why the aggregate demand curve slopes down- ward, 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 out- put is to note the link between money and transactions. If we assume that V is con- stant, 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. 3. If the Fed increases the money supply, then the aggregate demand curve shifts out- ward, as in Figure 9–2. In the short run, prices are sticky, so the economy moves along 74 AD Y Income, output P Price level Figure 9–1 CHAPTER 9 Introduction to Economic Fluctuations
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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 AD 2 to point C. At the new long-run equilibri- um, output is at its natural-rate level, but prices are higher than they were in the ini- tial equilibrium at point A. 4. 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.
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This note was uploaded on 02/22/2012 for the course ECON 602 taught by Professor Smith during the Spring '12 term at FSU.

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9Chapter-Mankiw - CHAPTER 9 Introduction to Economic...

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