Macro Chapter 1 long vs short run

Macroeconomics for
the long run and for
the short run
What is the subject matter of macroeconomics? What methods and simpli(ying
assumptions do macroeconomists use in their efforts to explruiain how the
economy works? These are the Issues addressed In thls Introductory chapter.
The chapter explains the philosophy underlying our course in macroeconomics. In
particular, it explains why we have divided the main body of the text intou two Books. one
concerned with the long run, and another one dealing with the short run. Reading this
chapter will help you to understand the links between the following chapters and to see
where the material in each individual chapter fitsiyui into the big scheme. In addition, this
chapter presents some important concepts and elements of macroeconomic models which
we will use repeatedly in later chapters.
We start by discussing how to define macroeconomics. We then go on to explain why
it is useful to develop separate macroeconomic theories lor the long run and for the short
run. Finally, we end the chapter by summing up the dillerent assumptions underlying
macroeconomic models for the short run versus macro models for the long run.
What is macroeconomics?
It seems natural for a macroeconomic textbook to start by giving a general definition of
macroeconomics. Yet you are not going to see a perfectly clear deflnition here; we simply
do not think that there is one. In fact. economists have even found it hard to oller a clearcut
dellnition of the general science of economics.
The economist and Nobel Prize wim1er Gary Becker once said that 'economics is the
study of the allocation of scarce resources to satisfY competing ends'. 1 This certainly says
something essential about what (mainly micro) economics is. However, some parts of
macroeconomics are concerned '.vith situations where resources are not scarce. because the
available supplies of labour and capital are not fully utilized. These important real-world
situations would not fall within the realm of economics according to the above definition.
Given the difficulties of providing a brief and accurate definition of economics, one
should not be surprised that a perfectly clear subdivision into micro- and macroeconomics
is also elusive. It is sometimes said that macroeconomics is that part of economics which
is concerned with the economy as a whole. This suggests that microeconomics focuses
only on the small elements of the economy such as the single agent or the market for a
particular product. Although much of macroeconomics is concerned with the economy in
the large, this distinction between macro and micro is inaccurate. Important parts of
macroeconomics are not (directly) concerned with the whole economy, but rather with
understanding particular markets such as the labour market or the credit market. And a
large and important part of microeconomics, general equilibrium theory, is concerned
with the interaction among markets. that is. with the economy as a whole.
We therefore think that the best characterization of macroeconomics is one that
simply states the main questions asked in this branch of economics.
A definition of macroeconomics by subject
What creates growth in aggregate output and income per capita in the long run? And
what causes the fluctuations in economic activity that we observe in the short run? These
are the basic questions in macroeconomics. At the risk of oversimplilying. we may therefore
say that macroeconomics is the study of eco11omic growth and lwsin ess cycles. As we shall
see later on, to explain the movements in total output we must also understand the movements
in total consumption, investment and the rate of unemployment, as well as the
interaction of these real variables with nominal variables such as the general level of
wages, prices, nominal interest rates, foreign exchange rates, etc. Hence macroeconomics
also includes the study of these variables.
A definition of macroeconomics by method
What we have offered above is a definition of macroeconomics by subject: macroeconomics
is defined by the issues studied by macroeconomists. A strict 'empiricist'
version of this definition. which also involves the choice of method, is to say that macroecmwmics
is concerned with explaining observed time series for eco11omic variables like GDP,
col!sumption, investme11t, prices a11d wages, the rate of unemployme11t, etc. This reflects the
view that a scientillc discipline should be dellned in terms of the data it seeks to explain.
We do not agree completely with this view. We do think there are some purely
theoretical scientific contributions that should be considered as part of the body of macroeconomics.
However, like the rest of the macroeconomics profession, we are heavily
influenced by the empiricist view. To secure the link between theory and the real world,
theories should be evaluated by holding them up against the facts, and new theory should
ideally be justified and accompanied by illustrative empirical material. You will see that
our book very much reflects this approach.
Economist Robert Solow (of whom you will hear a Jot more in this course) has put it
the following way:
All theory depends on assumptions which are not quite true. That is what makes it theory. The
art of successful theorizing is to make the inevitable simplifying assumptions in such a way
that the final results are not very sensitive. 3
The long run versus the short run
As we have noted, macroeconomics seeks answers to the questions 'what creates growth
in GDP per capita in the long run?' and 'what creates fluctuations in GDP in the short
run?' It also tries to answer some related questions like 'what explains the level oflong-run
unemployment?', and 'what explains the short-run variations in unemployment?'
Because these questions relate to dillerent time horizons, we have organized the main
body of this text in two Books, where the first is concerned with the long-run questions
above. and the second is concerned with the short-run questions.
We lind both parts of macroeconomics very important, but one can argue that the
issues addressed in long-run macroeconomics are the most important ones. Consider a
poor country like Uganda whose GDP per capita is only about 3 per cent of GDP per capita
in the United States. A typical policy issue in long-run macroeconomics is: h ow could a
country like Uganda initiate a growth process that would gradually take it up to, say, 20
per cent of the US level? A typical policy issue in short -run macroeconomics is: what could
a government in, say, the UK, Sweden, Denmark, or the Netherlands do to avoid an
increase in the rate of unemployment from 5 to 8 per cent which would otherwise follow
after a negattve shock to the economy? We do find the latter question very important,
but for anyone concerned with the long-run welfare of human beings, the first type of
question seems more essential.
1.2 long run vs short run
The distinction bea.veen long-run and short-nm macroeconomics is first and fundamentally a
distinction between the types of phenomena you want to understand. characteristics of the models we use, and of the policies
we analyse. Below we will motivate these statements and explain the nature of the
difference between long-run and short-run macroeconomic models.
Let us start by looking at some data. In Figs 1.1 and 1.2 we have chosen to focus on
two countries, the USA and Denmark, since these two nations can be seen as polar cases:
the USA is a large and relatively closed economy with a fairly small public sector (by
European standards), whereas Denmark is a small and relatively open economy with a
large public sector. We want to illustrate that, despite these differences, some important
qualitative features of the data are shared between the two economies. Similar figures
drawn lor countries like the UK, Sweden, the Netherlands, and for practically any
developed market economy would show the same qualitative features.
In Fig. 1.1 the natural logarithms of the rumual real GDPs of the USA and Denmark
are drawn up for the period from 1873 to 1995, with the value in 1873 indexed to 100 lor
both countries. Figure 1.2 shows the average annual rates of unemployment lor the two
countries during the past century. In both ligures the actual data are represented by the
most solidly drawn zig-zagged curves.
The ligures also include curves which are much more smooth. These are meant to
express the tre11ds ofthe relevant series. In Chapter 14 you will learn about a technique for
constructing such a trend (that technique has in fact been used here). For now let us just
view the trend curves intuitively as the curves which a man in the street would draw with
a pencil if he were asked to illustrate the 'underlying movement" or the 'underlying
gravity level'.
In any event, the figures suggest that one way to interpret the movements of each of
the series is to view them as being made up of two components: a trend componerrt representing
the overall evolution and captured by the smooth curves. and a cyclical component
representing the year-to-year fluctuations and captured by the shifting vertical deviations
between the actual data curve and the trend curve.
You may flnd that the cyclical components in Fig. 1.1 do not seem that great. To
highlight the fluctuations (around the long-run trend), we have drawn Fig. 1.3 which
shows the annual rate of change in real GDP. and the annual absolute change in the rate
of unemployment for the USA and Denmark for the shorter period 1980-2003. The
annual rate of change in GDP varies from sometimes higher than 6 per cent. dm>\ll1 to
sometimes around - 2 per cent. and the rate of unemployment occasionally increases by
up to two percentage points in just one year, and a lso sometimes drops by two points in
one year. These cyclical movements are of considerable size.
Macroeconomics for the long run is about understanding the trends in series like
those just shm>\ll1, representing the long-run growth in GOP and the long-nm or so-called
structural unemployment. respectively. Macroeconomics lor the short run is about
understanding the annual or quarterly .fluctuations in. lor instance. the GOP and the rate
of unemployment. Note how each part of macroeconomic theory corresponds to each of
the main questions asked in our deHnition of macroeconomics.
Most economists believe that an understanding of the trend requires a different type
of explanation than an understanding of the fluctuations. The dillerent macroeconomic
models are formal expressions of these different explanations. The fundamental assumptions
of the models for the long run and for the short run therefore diller, and hence the
models themselves become dillerent. 4 But why should there be diilerent macroeconomic
theories for understanding the trends and for explaining the fluctuations? We will now
consider this question in more detail.

1.3 macro for the short run

It may be illuminating to start with an example. Consider the Danish economy in 1993
and 1994 as illustrated in Fig. 1.3. In 1993 Danish real GOP was completely stagnant,
but then in 1994 it suddenly increased by about 5.5 per cent! This dramatic shift ailected
the rate of unemployment which dropped by almost two percentage points.
Exogenous shocks
A standard macroeconomic explanation for this short-run fluctuation would start by
saying that in 1994 the Danish economy was hit by a positive exogerwus shock. that is, by
a sudden event which is best seen as coming from outside the (Danish) economic system.
Such an event could be either a supply shock like a sudden increase in the productivity of
resources, or a demand shock like a sudden rise in domestic consumption or investment
rooted. for example, in more optimistic expectations concerning the future, or in a more
expansionary llscal or monetary policy, or in a sudden increase in the demand for Danish
exports. Danish llscal policy was in fact relaxed in 1993-94. and the real interest rate fell at that time. Moreover. the Danish export markets in Europe started to grow more
quickly in 1994. Thus we may assume that the 1994 shock was mainly a positive demand
shock.
To say that the sudden increase in Danish production was caused by an exogenous
shock, basically an unexplained event. is not exactly deep. But note two things. First,
economies are hit all the time by events which are best considered as exogenous from the
viewpoint of economic theory. For example. economists should not be concerned with
explaining fluctuations in harvests due to shifting weather conditions, and probably they
should not try to explain all sudden changes in the moods of consumers and investors.
Focusing on the small economy of Denmark. a sudden increase in the demand for exports
due to events in foreign countries should also be considered exogenous. Second. the occurrence
of the shock is not the end of the story. A shock may be what initiated the change in
economic activity, but it cannot itself explain all the subsequent economic reactions of
households and firms. There is more explanation to do.
Nominal rigidities
For an increase in the aggregate demand for goods and services to lead to an increase in
production . as observed in Denmark in 1994, it must have been prolltable lor Danish
flrms to increase their supply of output to accommodate the increase in demand. In the
short run the capital stock is more or less given, so production can only increase if more
labour is used. As more workers come to utilize the given capital stock, the marginal
productivity of additional hours worked is likely to decline. If the marginal productivity of
labour is indeed falling, it seems plausible that frrms will only want to expand employment
if the real wage falls. The real wage rate is dellned as W/P. where W is the money wage
rate and P is the price level. Presumably the higher demand for goods and services will
lead to some increase in P. If the nominal wage rate W is rigid in the short run. this rise in
prices will indeed cause a fall in the real wage, inducing firms to hire more labour to
increase their supply of output.
Thus another key ingredient in our explanation of the fluctuation is the assumption
of some short-run nominal rigidi ty, in this case a rigid money wage. The assumption th at
nominal wage rates are fixed for a certain period of time is quite realistic. Firms and
workers do not renegotiate their wage rates every day or every month. because negotiation
is a time-consuming process involving the risk of unpleasant and costly industrial
conflict.
But experience also indicates that the nominal prices of most goods and services are
only adjusted with certain time intervals. In an interesting empirical analysis of newsstand
prices of American magazines. economist Stephen G. Cecchetti found that under an
average general inflation of 4 per cent per year magazine prices were only changed every
6 years on the average. This means that on average the real price of a magazine is eroded
by about 2 5 per cent by inflation before the nominal price is changed.
The rigidity of nominal magazine prices is not just a special case. In an empirical
analysis of price rigidity. economist Alan Blinder asked a sample of business managers:
'How often do the prices of your most important products change in a typical year?' About
50 per cent of the managers responded that they only changed their prices once or less
than once a year. 6 Explaining why (most) firms do not immediately adjust their prices in
response to changes in demand and cost is an intriguing issue to which we return in
Section 5.
We argued above that a rigid nominal wage in association with a flexible. upward
adjusting nominal price could create the fall in real wages that would make it proiHable for
llrms to supply more output in response to a positive demand shock. If a fall in the real
wage is the typical reason why llrms want to increase their output in reaction to a positive
demand shock. we should expect to observe a negative relationship between output and
real wages. However, output often increases without a simultaneous decrease in real
wages. It is therefore important to ask if an increase in the demand for output can induce
llrms to increase their supply even if all nominal prices are llxed in the short run (so the
real wage does not fall)? The answer is 'yes', provided that prices are above marginal costs
before the demand shock hits the economy. In practice most markets are characterized by
imperfect competition where llrms have some monopoly power enabling them to charge
prices which are indeed above marginal costs. In that case they '>\Till be able to increase
their total prollt by increasing their output in response to an increase in demand, even if
they have to keep their prices temporarily tlxed.
The basic point is that short-run nominal price or wage rigidity can explain why an
exogenous increase in nominal aggregate demand leads to a short-run increase in real
output and employment. If nominal prices are flxed. all of the increase in demand '>\Till be
reflected in a rise in real output, because imperfectly competitive llrms will be happy to
increase their supply as long as their (fixed) prices remain above marginal costs. And even
if prices increase in response to higher demand. a rigid nominal wage means that the price
hike will drive down the real wage which in tum will stimulate employment and output.
In practice, both nominal wages and nominal prices are rigid in the short run, although to
different degrees in diflerent markets.
Expectational errors
So far our explanation for the short-run fluctuation in Danish output has relied on two
ingredients: exogenous shocks and short-run nominal rigidities. But there is a third ingredient
which is essential for a full understanding of the fluctuation: expectational errors. To
see this. consider the Danish boom in 1994 and suppose that there was in fact some fall in
the Danish real wage, as some prices increased in response to growing demand and
nominal wages Jagged behind. Faced with falling real wages, why were Danish workers
nevertheless willing to increase their supply of labour, thereby enabling firms to expand
employment and output? One possible answer is that trade unions in the heavily unionized
Danish labour market had pushed real wages above the marginal disutility of work so that some workers were involuntarily unemployed prior to the demand boom. By dellnition.
a worker who is involuntarily unemployed is willing to take a job even if the real
wage falls below its current level (provided it does not fall too much).
But this hypothesis only begs the question why trade unions faced with growing
labour demand would allow the real wage to fall? If unions were bargaining in 1993 to
achieve a certain real wage w for 1994, why would they suddenly accept that the real
wage fell below the target for 19 94 at a time when labour demand was increasing? The
most plausible answer is that the fall in real wages was uninte11ded by unions. If unions
h ad perfectly anticipated the positive 1994 demand shock and its ellect on the price
level, they would h ave bargained for a higher 1994 money wage rate to secure their
target real wage w, that is. they would have demanded a money wage satisfying
W =P·w.
However, since (most) wages had to be set before the occurrence of the shock. and
since the shock was 11ot perfectly foreseen, the negotiated money wage had to be based on
the expected price level P' which did not include the full inllationary effect of the shock:
W = P' · w < P · w. When the shock hit and prices increased above their expected level,
unions were locked into their nominal wage contracts. and given the employer's right to
hire more workers at the negotiated money wage, unions had to allow their members to
supply additional labour even though the realized real wage. W/P. turned out to be lower
than the target real wage, W/P'' = OJ .
This example illustrates our point that business lluctuations typically involve expectational
errors, in this case errors made by workers (trade unions). In the case where some
prices as well as money wages are rigid in the short run, an unanticipated shock will also
cause some firms to err in their expectations. When firms pre-set their prices for a certain
period. they will base their pricing decisions on their expected costs which will be influenced
by the expected general price level P''. When the unanticipated shock hits the
economy. some firms (call them Group 1) will be just about to adjust their prices and will
be able to account for the inflationary cost eflect of the shock. But many other firms
(Group 2) wh ich have recently reset their prices will choose to maintain their existing
prices for a while, even though the increase in the prices charged by Group 1 1lrms drives
the costs of Group 2 flrms above the previously expected level. As long as the shock does
not push marginal costs above the preset prices, even Group 2 llrms will want to expand
their output to accommodate the unexpected rise in demand.
Macroeconomics for the short run: summing up
We may sum up the points of this section as follows: mo.croeco11omic theory for the short ru11.
intended to explain the economic fluctuations from year to year or from quarter to
quarter, typically includes the following three modelling features:
1. exogenous shocks, i.e., sudden abrupt influences on the economy coming from changes
in preferences, technology, or economic policies.
2. short-run nominal rigidity, i.e., some period after the occurrence of a shock during
which some prices and/or wages are sticky.
3. expectational errors, i.e .. a period after the occurrence of a shock during which some
prices are different from what was expected before the shock.

1.4 Macroeconomic theory for the long run

While exogenous shocks. temporarily sticky wages or prices and erroneous expectations
are required for an understanding of the changes from year to year in unemployment and
GDP . most economists think that these features are best disregarded when we try to
explain the 'gravity level' of the rate of unemployment and the trend-wise gradual growth
of GDP over long periods. The smooth trend curves in Figs 1.1 and 1. 2 could not possibly
reflect a succession of random shocks over the more than 100 years considered. By definition,
shocks have to go in opposite directions from time to time. If technology improves
constantly each year to imply a 2 per cent increase in GDP per head, then this annual shift
in technology should not be considered as a shock. but rather as a foreseeable gradual
movement. Moreover. although nominal wages and prices may be sticky in the short run.
they do adjust in the longer run. In macroeconomics for the long run we therefore
abstract ti·om the three features which define short-run macroeconomics.
Long-run modelling: the basic assumptions
In other words. macroeconomic theory for the long run, intended to explain the trend-wise
movements of main economic variables around which the year-to-year fluctuations
occur, portrays the economy as if exogenous shocks do not occur, i.e., the economic fundamentals
like preferences and technology develop in a smooth and foreseeable way over
time; prices are ji.tl/y adjusted in all periods in accordance with the economy's full long-run
price flexibility; and expectations are correct all the time.
You should carefully note the 'as if in this definition. If the assumptions of macroeconomics
for the short run give the right picture. then in (almost) every year the
economy will be reacting to shocks, with prices still not fully adjusted and expectational
errors still prevailing. This is because new shocks occur all the time. Nevertheless, certain
phenomena may be better understood by considering the economy as if shocks did not
occur, prices are always fully aujusted. and in the long run are always correct. Among such
phenomena we include the long-run growth performance and the long-run gravity level
of unemployment. Thus macroeconomic models lor the long-run describe the underlying
long-run equilibrium towards which the economy is gravitating. even though recurring shocks and the time-consuming adjustment to these shocks imply that the economy is
never exactly in this long-run equilibrium.
To put it another way. in explaining how economic growth in Denmark could change
from zero per cent in 1993 to 5.5 per cent in 1994. and unemployment at the same time
be signiftcantly reduced, we have to allow lor exogenous shocks, price rigidities and
expectational errors. In an explanation of the average annual GDP growth of 3.4 per cent
over the period from 19 50 to 1998, or of the average rate of unemployment of 5.3 per
cent. it L~ better to abstract from these three complicating features to focus attention on the
fundamental forces governing the long-run evolution of the economy.
Real rigidities and natural rate theory
The assumption in long-run macroeconomics that all wages and prices are tully adjusted in
all periods means that there are no nominal rigidities in the long term. But there may well be
permanent real rigidities preventing real prices and wages from adjusting to the values
which would prevail under perfect competition. The economy's long-nm wage and price
flexibility can be different from the flexibility assumed in the traditional model of perfect competition.
We will now go through a simplified example to illustrate what we mean. For concreteness,
we will show how real rigidities may arise from the market power of trade unions.
but we emphasi7..e that even if unions are weak or non-existent, there are other mechanisms
which may cause significant real rigidities, as our analysis in Chapter 12 '.viii make clear.
Consider an economy divided into many different sectors. each represented by a fum
producing a dillerentiated product, and each having an industry trade union which controls
the supply oflabour to firms in the sector. Suppose lor simplicity that labour is the only
variable factor of production and that it takes one unit of labour to produce one unit of
output in each sector. The average and marginal cost of production for the individual fum
will then be equal to the wage rate for its industry. It is well known from microeconomics
that a prollt-maximizing firm facing a downward-sloping demand curve '.vith a constant
price elasticity of demand will set its price as a constant mark-up over its marginal cost. If
the average nominal wage level is W, the average price level P may thus be specilled as:
P=m1'W, mP > 1, (1)
where mP is the mark-up factor of the representative llrm.
Now consider the trade union monopolizing the supply of labour to a particular
sector i. To simplify. suppose the union is so strong that it can ellectively dictate the
nominal wage rate Wi to be paid by the firm representing sector i. The trade union sets
the wage rate with the purpose of maximizing the objective function Q , where:
Q = (-wj" - v) Li' (2)
Here Li is the level of employment in sector i, IA.';/P is the real wage for union members
employed in firm i, and v is the real income which members are able to earn elsewhere if
they fail to find a job in sector i. The variable v is sometimes referred to as the workers'
'outside option' and '.viii be specilled below. Since {11.1JP - v is the rent (surplus) which the
in dividual union member earns by being employed in firm i rather than having to look
for a job elsewhere. the magnitude Q is the total rent that union members gain from employment in firm i. In Chapter 13 we shall explain in detail why it is reasonable to
assume that the trade union wants to maximize this total rent; lor the moment we ask you
to accept this plausible assumption.
When setting the wage rate Wi, the union must take into account that a higher wage
will induce the firm to hire fewer workers. If the union charges an average wage rate so
that W/W = l, the firm in sector i will h ave the same cost level as its competitors in other
sectors and will experience an average volume of sales. The union may then expect to gain
a proportional share of total employment. so employment in sector i will be L/n. where Lis
aggregate employment and n is the number of diflerent sectors. But if the union for sector
i raises its relative wage rate, W/W. its employer \>Viii have to raise his relative output
price, leading to a lower volume of sales and employment in the sector. Noting from (1)
that W = P/mP, we may thus specify the demand for labour in sector i as:
(] > 1. ( 3)
where the parameter a measures the numerical wage elasticity oflabour demand. Since
the trade union for sector i is small relative to the rest of the economy, it takes the outside
option v and the general price level Pas given. By setting the nominal wage rate, Wi, the
union thus implicitly chooses its real wage. ~/P. Using (3) to eliminate Li from (2). and
differentiating the resulting expression for Q with respect to Hl;. we obtain a necessary
(first order) condition for the optimality of the wage rate set by the union. Since the logfunction
is increasing we may as well difl"erentiate the log of Q, which is convenient here:

We see that the union will set the real wage as a constant mark-up over the outside
option. Let us take a closer look at this option. If the unemployment rate is u, the representative
union member has a probability 1 - u of finding another job if he has to look for
work outside sector i. In that case he may expect to earn the average real wage W /P. There
is also a probability u that the union member \>Viii remain unemployed if he does not obtain
a job in sector i. In that situation the worker will receive a real unemployment benefit, b,
assumed to be lower than the average real wage. The outside option. defmed as the real
income a worker may expect to earn outside sector i, may thus be specified as:

From ( 4) and ( 5) we may derive a simple theory of long-run unemployment which
will help to clarify the concept of real rigidities. Inserting (5) into ( 4 ), and denoting the real
wage rates inside and outside firm i by wi and w, respectively, we get:

Note that a positive unemployment rate emerges even though we did not assume any
nominal rigidities: the nominal variables Wand P can be fi:'eely scaled up or down in the
equations above.
The unemployment problem is rooted in the market distortions reflected in the
mark-up factors m" and m w. If there were no unions and labour markets were perfectly
competitive, workers could not drive wages above their outside option. According to our
simplified model equilibrium unemployment would then be zero, as you can see by setting
m w = 1 In ( 8). But unions do exist and do have market power. g In the situation where
mw> 1, the unemployment generated by union monopoly power will be ~:acerbated by
imperfect competition in product markets. This is because weaker product market competition
implies a higher value of the price mark-up. mt'. and according to (8) this 11Vill
increase the value of u: when firms drive down the level of real wages by pushing prices
above marginal costs, the amount of involuntary unemployment must rise to bring union
wage claims down in line with the real wages implicitly otlered by firms through their
monopolistic price setting. We also see from (8) that a higher level of unemployment
benefits will raise the equilibrium unemployment rate when unions have market
power.

When economists speak of'real rigidities' , they often mean that market imperfections
permanently distort the real prices and real wages claimed by Hrms and workers away
from the competitive relative (real) prices which would ensure full resource utilization.
Even in the long run, when all nominal wages and prices have had time to ft1lly adjust to
their desired levels, these structural market distortions will persist, leaving the economy in
a state of permanent unemployment. Our analysis suggests that the degree of real rigidity
in the economy may be measured by the size of the parameters m ••, mP and b which contribute
to equilibrium unemployment. Alternatively, we might simply measure the degree
of real rigidity by the size of the equilibrium unemployment rate, since we have seen that
IT= 0 in the benchmark case of perfect competition.
According to established tradition in macroeconomics, the long-run equilibrium
unemployment rate implied by the economy's real rigidities is called the rwtural rate. This
is the rate of unemployment emerging when all relative prices have fully adjusted in
accordance with the economy's long-run wage and price flexibility. In line with this tradition,
we will use the term 'natural rate of resource utilization' to denote the rate at which
factors of production are utilized in long-run equilibrium when the economy has
exhausted its potential for price adjustment. By dellnition, there are no real rigidities if
perfect competition prevails, since real (relative) prices in a competitive economy adjust
until the demand for each resource equals the full supply ofthat resource. Th is just means
that the natural rate of resource utilization is 100 per cent. If real rigidities do exist, the
natural rate of resource utilization will be less than 100 per cent.
We have suggested that the degree of real rigidity may be measured by the level of the
natural unemployment rate. We should add that economists sometimes Hnd it fruit!ul to
work with a slightly dillerent concept of real rigidity. In this alternative definition . the
degree of real rigidity is measured by the responsiveness of real wages and real prices to a
short run cha~~ge in the unemployment rate away from the natural rate. If this responsiveness
is low, the degree of real rigidity is said to be high . In Section 5 we \<\Till adopt this alternative
notion of real rigidity which \<\Till turn out to be useful for explaining short-run
nominal rigidities. At any rate, real rigidity in a broad sense refers to the fact that the
economy's degree of relative price flexibility is less than it would be in an ideal world of
perfect competition.
The crucial role of the supply side in long-run modelling
As indicated by the simple example in equation (8) . the natural rate of employment. 1 - fi,
is given from the supply side of the economy, since the parameters m••, mP and b are
characteristics of the economy's supply side structures. This has an important implication:
in macroeconomic models for the long run, where wages and prices are assumed
to be fully adjusted in all periods, output is determined solely from the supply side. In any
given period there is a certain labour force L, and a certain (predetermined) capital stock
K. Output is then completely constrained from the supply side, since it cannot exceed
the volume which can be produced by means of the labour input (1 - u)L and the
predetermined capital input K.
By contrast, in short-run macroeconomic models nominal wage and price rigidities
and/or expectational errors may cause employment to deviate from its natural rate.
Hence we do not have the simple supply side determination of employment just described.

Instead, employment is also intluenced by the aggregate dema11d for goods and services.
Thus, in long-run macroeconomic models employment always corresponds to the natural
rate, whereas in short-run models employment is determined also from the demand side
and lluctuates around the natural rate.
Static versus dynamic models
A macroeconomic model for the long run can be a single-period static model. This
may seem surprising, but sometimes it is useful to focus on a single period which is an
'end period' in the sense that no new shocks have occurred for a long time and the
economy has Hnished all its adjustments. One then just describes the economy in the end
period. The purpose is to characterize the equilibrium towards which the economy is
tending in the long run, without complicating the theory with an explicit analysis of the
dynamic process which takes the economy to the long-run equilibrium. The models of
long-run structural unemployment presented in Chapters 12 and 13 will be of this
nature.
By contrast. dynamic models for the long run describe the process of capital accumulation
explicitly, and typically they also describe the evolution of other important stock
variables such as the labour force. the stock of natural resources, etc. These models. also
called growth models. always contain the following dynamic link between the current
flow of investment and the increase in the stock of capital:
(9)
where K, is the amount of capital available in period t, I1 is gross investment in period t.
and c~ is the rate at which capital depreciates. 0 < (5 < 1. In a closed economy the level
of gross investment I1 must equal gross savings S1• Por a closed economy the capital
accumulation equation therefore becomes:
(10)
Thus savings play a central role in growth models. In many models it is simply assumed
that households always save an exogenous fractions of total income so that in any period
t we have S1 = sY1• The growth models using this assumption, are called Solow models. 9
There are more advanced growth models in which savings are derived from maximization
of utility functions under appropriate budget constraints. We leave these more
complicated models lor a later macroeconomics course. Solow models are well suited and
widely used lor understanding many growth issues. However. for analysing the eflects of
economic policies, these models have the shortcoming that they do not contain utility
functions and therefore do not allow an explicit evaluation of the welfare consequences of
alternative economic policies. In Solow models one will just have to look at the policy
implications lor economic variables like GDP or the level of consumption, and simply
assume that it is 'good' to have high per capita income or consumption.

explaining nominal rigidities

We noted earlier that some form of nominal rigidity typically plays an important part in
the explanation of short-run business fluctuations. As we shaU demonstrate in this
section, the phenomenon of real rigidity discussed in the previous section may help us
understand how short-run nominal rigidity may be compatible with rational economic
behaviour. Specillcally, we \>\Till show that when target real wages are not very responsive
to changes in the level of economic activity, even very small costs of nominal wage or price
adjustment may be sullkient to induce rational agents to abstain from adjusting nominal
wages or prices in the short run in response to fluctuations in economic activity.
It is not unreasonable to assume that there are some small costs of adjusting nominal
wage rates. For example, union leaders may have to spend some time sitting down at the
bargaining table with the employer to write a new wage contract. Moreover. when the
demand for labour changes, wage setters may have to spend some resources estimating
the exact magnitude of the change if they want to be sure that they set the optimal wage
rate. Similarly. Hrms may incur small costs in resetting their nominal prices. For instance.
they may have to print new catalogues or spend other resources communicating the new
prices to the market.
The costs of adjusting nominal prices or wages are often referred to as ;menu costs',
like the costs to a restaurant of having to print a new menu card. In most cases such costs
are likely to be quite small, and hence they are usually neglected in economic models. But
if we can show that even very small menu costs may be sufficient to induce economic
agents not to adjust nominal wages or prices in response to even considerable shocks, we
have a potential explanation for the nominal rigidities which seem to exist in the real
world. 10
Explaining nominal wage stickiness
We start by considering the circumstances in which nominal wage rigidity may be the
outcome of optimizing economic behaviour. Our strategy is to measure the loss incurred
by individual wage setters if they do not adjust their nominal wage rate in reaction to a
change in the unemployment rate of a realistic magnitude. If this loss is very small. then
the privately optimal behaviour may be to leave the wage rate unchanged to avoid the
cost of wage adjustment.
We base our analysis on the simple model of wage formation developed in the previous
section. For convenience. we now assume that the system of unemployment
insurance offers a fixed compensation relative to the average wage level, b = cw, where the
replacement rate c < 1 is a constant. Recalling that w = W(P, the outside option (5) may
then be \-vritten as a function of the unemployment rate:

claim. despite the sharp rise in unemployment. If the rise in the unemployment rate is only
1 percentage point (still a substantial 20 per cent increase in unemployment), our parameter
values imply that the 'menu costs' of wage adjustment only have to make up a tiny
0 .0 5 per cent of the wage bill to generate nominal wage rigidity. Adjustment costs of such
small magnitude certainly do not seem unlikely.
To sum up, even very small menu costs may cause the individual trade union's
nominal wage claim to be rigid in the short run, and as a consequence the general
nominal wage level will be rigid.
The link between real and nominal rigidity
Notice how nominal and real rigidities are intimately linked: the term (1~'; - w ;)/w; appearing
in (1 7) measures how much the union would like to change its real wage rate if adjustment
were costless. Hence (IV; - w;)/w;may be seen as an inverse measure of the degree of
real wage rigidity. The smaller this magnitude. the weaker is the desire for real wage
adjustment in response to fluctuations in unemployment. so the higher is the degree of
real wage rigidity. and vice versa. And the greater the degree of real wage rigidity, the
smaller are the menu costs needed to prevent 11ominal wage adjustment. so the higher is
the degree of nominal wage rigidity. On the other hand, if(l:\';- 111;)/w; is large, reflecting a
low degree of real rigidity, small menu costs are unlikely to prevent nominal wage adjustment,
according to (17). In short. a relatively h igh degree of real wage rigidity seems to be
a necessary condition lor nominal wage rigidity.
In our trade union model of wage setting and unemployment. the degree of real wage
rigidity is indeed quite high. because a change in the unemployment rate only h as a small
impact on the value of the outside option lor the average worker. given plausible parameter
values. Of course the results from such a simplilled model should not be taken too
literally. However. other theories of imperfect labour markets such as the theory of
'elllciency wages' presented in Chapter 12 also tend to imply fairly rigid real wages. and
the empirical evidence presented in Chapter 14 suggests that the correlation between real
wages and economic activity is quite weak whereas the correlation between output and
employment is very strong. as one would expect if real wage rigidity is important in
practice. Thus the theory outlined here may indeed be an interesting candidate for
explaining nominal wage rigidity.
Explaining nominal price rigidity
The menu cost theory may also explain the rigidity of nominal prices. Obviously. if firms
set their prices in accordance with our mark-up price setting equation P = m1' W, and ifthe
nominal wage rate is rigid. it follows that nominal prices will also be rigid.
But even if there is 110 nominal wage rigidity, there may still be nominal price rigidity.
If we assume zero costs of nominal wage adjustment so that nominal wages are fully
flexible. the labour market model set up above still implies considerable real wage rigidity
for reasonable parameter values. This means that wage setters (unions) 1<\Till not want to
change nominal and real wage rates very much when economic activity ch anges, despite
the fact that wage adjustment is costless. Consequently ftrms will only experience
moderate fluctuations in their real wage costs over the business cycle. One can construct plausible examples in which this rigidity in the real production costs ofllrms will generate
nominal price rigidity even when the menu costs of price changes are very small.
This parallel between the lack of incentives lor wage and price adjustment may be
explained as follows: in our model of union wage setting the outside option is the union's
real opportunity cost of 'selling' an extra job to the owner of firm i through wage moderation
(since the outside option is the real income a union member could have earned elsewhere
in the labour market). Because the outside option is rather insensitive to changes in
unemployment, the union loses little by not adjusting its wage rate. Similarly, if the Hrm's
real labour cost of producing and selling an extra unit of output is insensitive to the
business cycle, it has little incentive to adjust its real price, and hence it will olten abstain
from adjusting its nominal price in order to save menu costs.
Since the individual llrm takes the prices set by all other Hrms as given, a decision by
firm ito change its nominal price P; is also a decision to change its real (relative) price, P/P.
Hence nominal price rigidity is a rellection of real price rigidity, just as nominal wage
rigidity arises from real wage rigidity.
Final observations on nominal rigidities
It should be emphasized that although the cost to the individual union (the private cost)
of not adjusting its wage rate is likely to be small, the social cost of nominal wage rigidity
may be substantial. The reason why the individual union estimates such a small gain
from adjusting its own nominal wage is that it takes all other wages and prices as given.
But if all unions could be induced to cut their nominal wage rates simultaneously in
response to a drop in aggregate employment, they would collectively drive down the
rate of inflation (via the price-setting equation P = mP W') , and as we shall see in Book
Two, this will tend to increase real aggregate demand. In this way it might be possible to
limit the fall in output and employment signiHcantly. Take our Hrst numerical example
above: if a coordinated downward adjustment of wages and prices could secure an
expansion of aggregate demand which would cut the two percentage point rise in
unemployment in half. total output and real income would rise by more than 1 percentage
point relative to the baseline scenario where no nominal adjustment takes place,
given the assumption underlying our price setting equation that the production function
is linear in labour input. 12 Against this signillcant income gain must be set the
small menu cost of wage adjustment which is only 0.2 per cent of the wage bill, and
hence an even smaller percentage of total GDP. Thus, since nominal wage rigidity
causes a substantial loss of output. its social cost is many times as large as the perceived
private cost of non-adjustment of nominal wages. For exactly the same reasons, the
social cost of nominal price rigidity is likely to be many times as great as the private cost
perceived by individual price setters. This is why the problem of nominal rigidity should
be taken seriously.
Finally, we should stress that the menu cost theory outlined here is only intended to
explain short-run nominal rigidities. Over time as shocks accumulate, agents who keep their wages or prices constant are likely to be pushed ever further away from their optimal
wages and prices. Eventually they '>\Till therefore find it optimal to pay the menu cost to
realign their relative price position: in the long run wages and prices do adjust.

1.6 Long run vs short run economic policies

A main motivation for studying economic phenomena is the need to improve the basis lor
economic policy advice. For instance, we want to understand the sources of economic
growth because this could be helpful in designing a growth-promoting policy lor a lowincome
country trying to escape poverty.
The division of macroeconomics described above leads to a parallel division of
economic policies into lo11g-run policies aimed at promoting growth and long-run prosperity
and at reducing long-run unemployment. and slwrt-run policies aimed at mitigating
economic fluctuations and their harmful consequences coming, for example, from sudden
increases in unemployment.
However. the division of macroeconomics suggests more than this categorization of
policies according to their aims. The basic and dillerent assumptions underlying the two
parts of macroeconomic theory have consequences lor the channels through which longrun
and short-run policies can allect the economy.
For example, recall that long-run macroeconomics assumes full nominal wage and
price adjustment. As we saw from Eq. (8), this implies that long-run unemployment is
determined exclusively by the parameters m'•. rrzP and b which reflect the structural
characteristics of labour and product markets. Because it is rooted in the basic structural
features of the economy, the natural rate of unemployment is also referred to as the
'stmctural' unemployment rate. It follows that a policy intended to reduce long-run
unemployment can only be successful if it allects the economy's basic structures.
Specifically, our analysis suggests that such a policy must try to increase the degree of
competition in labour or product markets (by lowering the values of mw and m1' ) and/or
reduce the generosity of the system of unemployment insurance (lowering b). 13
In a similar way, policies aimed at promoting long-run growth and prosperity must
all"ect one or several structural characteristics of the economy such as the long-run
propensities to save and invest, to engage in education and R&D, etc. In short, policies lor
the long run must be structural policies.
A short-run policy to mitigate business cycles. on the other hand, can be a monetary
or fiscal policy of demand management. Such a policy can affect the rate of employment in
the short run even if it does not influence the basic structures and incentives in the
economy. The reason is that in the short run prices and expectations are not fully
adjusted, and hence changes in nominal demand will allect real economic variables, as we
explained earlier.

1.7 summary

This chapter has explained the ideas behind the structuring of our course in macroeconomics.
Understanding these ideas is important for a good understanding of this book. Let us therefore
summarize our main concepts and arguments, taking the key elements in a different sequence
which will help to clarify the distinction between macroeconomics for the long run and macroeconomics
for the short run:
1. The economy's long-run equilibrium is the combination of relative prices and quantities which
would emerge in a general equilibrium where wages and prices have had time to adjust fully
to past shocks and where no further shocks have occurred over a sufficiently long period.
2. If the long-rur equilibrium is the outcome of perfect competition, all economic agents have
taken wages and prices as given and found their optimal price-taking supplies and demands,
and prices have adjusted to equate these supplies and demands market by market.
3. In practice empirical studies often find that prices are above marginal costs, indicating that
most markets- including the labour market- are characterized by imperfect competition. Still
we can think of long run relative prices as being determined by an underlying general equilibrium
system, although not one that ensures equality between price-taking supplies and
demands.
4. The natural rate is the rate of resource utilization emerging when relative prices have fully
adjusted to their long-run equilibrium values. Imperfect competition typically means that the
natural rate is less than 1 00 per cent. When this is the case, we say that real rigidities prevail.
Real rigidities imply that individual agents do not wish to reduce their real (relative) wages and
prices very much in response to unemployment or excess capacity. Hence real wages and
prices do not adjust sufficiently to prevent permanent underutilization of resources.
5. Macroeconomics for the long run aims at explaining the trends in main economic time series
and the effects of structural economic policies. In long-run macroeconomics the economy is
analysed as if relative prices are fully adjusted to their long-run equilibrium values in each
period, the fundamentals of the economy such as preferences and technology evolve
smoothly and predictably, and expectations are correct all the time. One implication is that in
long-run macroeconomics aggregate output is determined from the supply side alone, as the
level of output that can be produced when available resources are utilized at their natural
rates.
6. Short-run nominal wage and price rigidities mean that some money wages and/or prices are
fixed over a certain period. Empirical evidence shows that most money prices and money
wages are only adjusted with certain time intervals even under considerable inflation. Thus
nominal rigidities prevail in the short run, and these may cause the rate of resource utilization
to deviate from the natural rate for periods of sufficient length to be of interest.
7. Individual agents adjust their nominal wages or prices with the purpose of changing their real
wages or prices. Because real rigidities imply that agents do not want to change their real
prices very much in response to changes in economic activity, real rig idities also tend to
generate nominal rigidities. When the degree of real rigidity is strong, short-run nominal wage
and price rig idities can be privately optimal even if the menu costs of nominal wage and price adjustment are very small. At the same time the social cost of nominal rigidity can be many
times as large as the perceived private cost for the individual agent.
8. Short-run nominal wage and price rigidities may imply that some relative prices are also fixed
in the short run. For instance, if both nominal wages and nominal prices are fixed, real wages
are fixed. Short-run nominal rigidities can explain why it takes time for relative (real) prices to
adjust to their long-run equilibrium levels.
9. Macroeconomics for the short run seeks to explain the fluctuations in main economic time
series around their trends and the effects of stabilization policies. Economists believe that
exogenous shocks (sudden unpredictable changes in factors such as business confidence,
preferences and technology), short-run nominal wage and price rigidities, and expectational
errors are fundamental for understanding short-run fluctuations. Because of nominal rigidities
and expectational errors, the actual rate of resource utilization can deviate from the natural
rate. In the short run aggregate demand is therefore just as important for economic activity as
aggregate supply.