Macroeconomics

9-2

Time Horizons in Macroeconomics

Now that we have some sense about the facts that describe short-run econom-

ic fluctuations, we can turn to our basic task in this part of the book: building a

theory to explain these fluctuations. That job, it turns out, is not a simple one. It

will take us not only the rest of this chapter but also the next five chapters to

develop the model of short-run fluctuations in its entirety.

Before we start building the model, however, let’s step back and ask a funda-

mental 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 con-

sistently reminded its reader, is that classical macroeconomic theory applies to the

long run but not to the short run. But why is this so?

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, various economic events and policies have different effects over differ-

ent 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 reduces

the money supply by 5 percent. According to the classical model, the money sup-

ply affects nominal variables—variables measured in terms of money—but not

real variables. As you may recall from Chapter 4, the theoretical separation of real

and nominal variables is called the classical dichotomy, and the irrelevance of the

money supply for the determination of real variables is called monetary neutrality.

Most economists believe that these classical ideas describe how the economy

works in the long run: a 5-percent reduction in the money supply lowers all

prices (including nominal wages) by 5 percent while output, employment, and

other real variables remain the same. Thus, in the long run, changes in the money

supply do not cause fluctuations in output and employment.

In the short run, however, many prices do not respond to changes in mon-

etary 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 com-

pletely to changes in the money supply (as well as to other exogenous changes

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in economic conditions) means that, in the short run, real variables such as out-

put 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.

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P A R T   I V

Business Cycle Theory: The Economy in the Short Run

If You Want to Know Why Firms Have Sticky

Prices, Ask Them

How sticky are prices, and why are they sticky? In an intriguing study, econo-

mist Alan Blinder attacked these questions directly by surveying firms about their

price-adjustment decisions.

Blinder began by asking firm managers how often they changed prices. The

answers, summarized in Table 9-1, yielded two conclusions. First, sticky prices

are common. The typical firm in the economy adjusts its prices once or twice

a year. Second, there are large differences among firms in the frequency of

price adjustment. About 10 percent of firms changed prices more often than

once a week, and about the same number changed prices less often than once

a year.

Blinder then asked the firm managers why they didn’t change prices more

often. In particular, he explained to the managers several economic theories of

sticky prices and asked them to judge how well each of these theories described

their firms. Table 9-2 summarizes the theories and ranks them by the percent-

age of managers who accepted the theory as an accurate description of their

CASE STUDY