9.1 Time Horizons in Macroeconomics


Before we start building a model to explain 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?

How the Short Run and the Long Run Differ

Most macroeconomists believe that the key difference between the short run and the long run is the behaviour 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 Bank of Canada suddenly reduced the money supply by 5 percent. According to the classical model, the money supply 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 explain 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 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 catalogues, 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 to changes in the money supply (as well as to other exogenous changes in economic conditions) 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.


If You Want to Know Why Firms Have Sticky Prices, Ask Them

How sticky are prices, and why are they sticky? As we have seen, these questions are at the heart of new Keynesian theories of short-run economic fluctuations (as well as of the traditional model of aggregate demand and aggregate supply). In an intriguing study, economist Alan Blinder attacked these questions directly by surveying firms about their price-adjustment decisions.

Blinder began by asking firm managers how often they change prices. The answers, summarized in Table 9-1, yielded two conclusions. First, sticky prices are quite 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 change prices more often than once a week, and about the same number change prices less often than once a year.

TABLE 9-1 The Frequency of Price Adjustment
This table is based on answers to the question: How often do the prices of your most important products change in a typical year?
Frequency Percentage of Firms
Less than once 10.2
Once 39.3
1.01 to 2 15.6
2.01 to 4 12.9
4.01 to 12 7.5
12.01 to 52 4.3
52.01 to 365 8.6
More than 365 1.6

Source: Table 4.1, 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.


Blinder then asked the firm managers why they don’t change prices more often. In particular, he explained to the managers 12 economic theories of sticky prices and asked them to judge how well each of these theories describe their firms. Table 9-2 summarizes the theories and ranks them by the percentage of managers who accepted the theory. Notice that each of the theories was endorsed by some of the managers, and each was rejected by a large number as well. One interpretation is that different theories apply to different firms, depending on industry characteristics, and that price stickiness is a macroeconomic phenomenon without a single microeconomic explanation.

TABLE 9-2 Theories of Price Stickiness
Theory and Brief Description Percentage of Firms That Accepted Theory
Coordination failure: Firms hold back on price changes, waiting for others to go first 60.6
Cost-based pricing with lags: Price rises are delayed until costs rise 55.5
Delivery lags, service, etc.: Firms prefer to vary other product attributes, such as delivery lags, service, or product quality 54.8
Implicit contracts: Firms tacitly agree to stabilize prices, perhaps out of “fairness” to customers 50.4
Nominal contracts: Prices are fixed by explicit contracts 35.7
Costs of price adjustment: Firms incur costs by changing prices 30.0
Procyclical elasticity: Demand curves become less elastic as they shift in 29.7
Pricing points: Certain prices (e.g., $9.99) have special psychological significance 24.0
Inventories: Firms vary inventory stocks instead of prices 20.9
Constant marginal cost: Marginal cost is flat and markups are constant 19.7
Hierarchical delays: Bureaucratic delays slow down decisions 13.6
Judging quality by price: Firms fear customers will mistake price cuts for reductions in quality 10.0

Source: Tables 4.3 and 4.4, 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.


Among the 12 theories, coordination failure tops the list. According to Blinder, this is an important finding, for it suggests that the theory of coordination failure explains price stickiness, which in turn explains why the economy experiences short-run fluctuations around its natural level. He writes, “the most obvious policy implication of the model is that more coordinated wage and price setting—somehow achieved—could improve welfare. But if this proves difficult or impossible, the door is opened to activist monetary policy to cure recessions.”1 image

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 favourite 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 labour and on the available production technology. This is the essence of the models developed in Chapters 3, 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 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. In the remainder of this chapter we get a first glimpse at those interactions by examining the model in its most simplified form. Our goal is not to explain the model fully but instead to introduce the its key elements and to illustrate how it can help explain short-run economic fluctuations.