Time Horizons in Macroeconomics: The Short and Long Term

Long-Term Macroeconomics

In long-term macroeconomic theory, it is typically assumed that the classical dichotomy holds. In other words, there is a clear separation between nominal and real variables. As a result, monetary neutrality is assumed in the long run, meaning that changes in the money supply do not affect real variables. Additionally, long-term theory usually assumes flexible prices, which adjust to changes in supply and demand, allowing markets to reach equilibrium. The short-term price rigidities that are present eventually disappear over the long term.

Long-term macroeconomics seeks to explain trends in real variables over time, such as the behavior of real GDP and the employment of production factors.

Short-Term Macroeconomics

In short-term macroeconomic theory, the assumption of sticky prices is often adopted. This means that prices do not adjust easily, and markets may struggle to reach equilibrium. Furthermore, it is generally assumed that the classical dichotomy does not hold in the short run, meaning that nominal variables can affect real ones. As a result, monetary neutrality does not apply in the short term, and changes in the money supply can influence real variables like output and unemployment.

Short-term variables deviate from their long-term trends, and short-term macroeconomics aims to explain these deviations using various economic models. These models typically assume that the classical dichotomy is not appropriate in the short term, meaning that nominal and real variables are interconnected. Changes in the money supply can temporarily push real GDP away from its long-term trend, but in the long run, changes in the money supply will only affect prices and other nominal variables, leaving real variables unaffected.

By abandoning the classical dichotomy and monetary neutrality in the short term, models must focus on explaining how nominal and real variables interact. These models, which seek to explain short-term fluctuations or deviations from long-term trends, focus on the economy's output and the overall price level. Since output is a real variable and the price level is nominal, relating the two means abandoning the assumption that nominal and real variables can be studied separately.

Differences Between the Short and Long Term

The primary difference between short-term and long-term macroeconomic theory lies in price behavior. In the long term, prices are flexible and able to respond to changes in supply and demand. In contrast, in the short term, many prices are sticky and fixed at a certain level. Due to this difference in price behavior, the effects of economic events and policies vary depending on the time horizon being analyzed.

In the short term, changes in output are driven by demand fluctuations, and it is often assumed that firms are willing to supply as much as is demanded, essentially ignoring supply constraints. In the long term, other factors come into play, such as education systems, savings rates, and the role of government.

For example, according to classical models where the classical dichotomy and monetary neutrality hold, an increase in the money supply by the central bank does not cause fluctuations in output or employment. However, in the short term, many prices do not respond immediately to an increase in the money supply. This price stickiness implies that the short-term impact is different from the long-term effect.

Any model aiming to explain economic fluctuations must account for short-term price stickiness. The failure of prices to adjust immediately to changes in the money supply means that, in the short term, real variables like output and employment may bear some of the adjustment instead.

Conclusion

In summary, in the short term, prices are sticky, and the classical dichotomy does not hold. Nominal variables can influence real variables, and the economy may deviate from the trends predicted by long-term models. Conversely, in the long term, prices are flexible, the classical dichotomy holds, and the economy follows a long-term trend that economists seek to explain.

It is important to note that no specific time frame defines the short or long term. There is no standard for these horizons, but as a general rule, the short term refers to year-to-year changes or shorter periods, while the long term typically refers to changes spanning decades. The medium term is also commonly mentioned as the period during which the economy transitions from the short to the long term.