Macro chapter 1 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.

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