Chapter 6 Markets, Prices, Supply, and Demand

Chapter 6 Markets, Prices, Supply, and Demand

Objective: understand short-run economic fluctuations.

Micro foundations: the choices made by consumers and firms.Supply and demand behavior.

The neoclassical way: the market clears.

Timing

States: Bt-1, Kt-1, Pt-1, Mt-1

They are values at the end of period t-1, or at the beginning of period t.

They are real or nominal assets at the end of period t.

Timing Economic agents (period t)

Firm: Yt=AtF(Kt-1, Lt);Consumer: U(Ct, 1-Lt);Both are price-takers.

Markets (period t)Rental market: Rt-1;Bonds market: it-1;Labor market: wt;Money market: Pt.

Timing Controls: Ct, Lt, Bt, Kt,

They are household’s decisions based on observed prices and real assets;

Real assets include interest and rental income paid in period t.

States at the end of period t: Bt, Kt, Pt, Mt

Markets in the Macroeconomy Direct ownership of firms: no stock market. The goods market: nothing peculiar. The labor market

Inelastic supply of labor: Ls=Lt;

Ld determined by firms’ behavior. The rental market

Inelastic supply of capital: Ks=Kt-1;

Kd determined by firms’ behavior.

Markets in the Macroeconomy The bond market: borrowing between househo

lds. The money market

Inelastic supply of money: Ms=Mt;

Household demands md=Md/Pt.

Money as a Medium of Exchange All exchange uses money. Dollar amounts are nominal terms. Money earns no interest.

Markets and Prices The money market

The general price level: Pt.

The labor marketNominal wage: wt.

Real wage: wt/Pt.

Markets and Prices The rental market

Nominal rental price: Rt-1.

Real rental price: Rt-1/Pt.

Nominal rental income (payment): Rt-1Kt-1.

The bond marketNominal interest rate: it-1.

Nominal interest income: it-1Bt-1.

In aggregation, the net borrowing must be zero.

The Budget Constraint Nominal income

Profit: t=PtAtF(Kt-1, Lt)-(wtLt+Rt-1Kt-1)

Wage income: wtLt.

Rental income: Rt-1Kt-1. Net nominal rental income: Rt-1Kt-1-PtKt-1. Rate of return: Rt-1/Pt-.

Interest income: it-1Bt-1.

Total income: t+wtLt+(Rt-1/Pt-)PtKt-1+it-1Bt-1.

The Budget Constraint Nominal rates of return from t-1 to t:

On bonds: it-1;

On capital: ;

Real rates of return from t-1 to t:

On bonds: ;

The Fischer equation:

On capital: .

1 1 1 1

1 1 1

t t t t t t

t t t t

R K PK R P

P K P P

11 1(1 ) 1t

t tt

Pr i

P

1t

t

R

P

11 1 1 1

1

11

1t

t t t tt

ir r i

The Budget Constraint Nominal consumption: PtCt. Assets

Capital, bonds, and money.Nominal income from holding money: zero.Capital and bonds must yield the same real rates of

return.

The nominal income can be put as

t+wtLt+rt-1PtKt-1+it-1Bt-1=t+wtLt+rt-1PtKt-1+((1+rt-1)Pt/Pt-1-1)Bt-1

11

tt

t

Rr

P

The Budget Constraint Household budget constraint

Nominal value of assets: Mt-1+Bt-1+PtKt-1.

Nominal saving: Mt+Bt+PtKtBudget constraint in nominal terms:

PtCt+Bt+PtKt+Mt=t+wtLt+it-1Bt-1+rt-1PtKt-1Budget constraint in real terms:

11 1 1

t t t t tt t t t t t

t t t t t

B M w BC K L i r K

P P P P P

The Budget Constraint The budget line

Market Clearing Profit maximization

The firm tries to maximize the real profit:

Assuming competitive behavior: price taker.Maximize profit by choosing over Kd and Ld.

1( , )d d d dt t tt

t t t

w RAF K L L K

P P P

Market Clearing The labor market

Demand for labor: The production function exhibits diminishing marginal

productivity in labor; The labor demand curve is downward sloping.

Supply of labor: Ls=Lt.

Market clearing:

1( , )dt t

wAF K L

L P

1( , ) tt t

t

wAF K L

L P

Market Clearing Labor market clears

Market Clearing The Market for capital services

Demand for capital: The production function exhibits diminishing marginal

productivity in capital; The demand curve for capital is downward sloping.

Supply of capital: Ks=Kt-1.

Market clearing:

The real interest rate:

( , )dt

RAF K L

K P

11( , ) t

t tt

RAF K L

K P

11 1( , )t

t t t tt

Rr A F K L

P K

Market Clearing Market of capital services clears

Market Clearing Zero profit at equilibrium

11 1( , )t t t

t t t t tt t t

w RAF K L L K

P P P

11 1( , ) ( , )t t

t t t t t tt t

w RAF K L AF K L

P L P K

1 11 1

( , ) ( , )( , )

0

t t t t tt t t t t

t

F K L F K LA F K L L K

P L K

The budget constraint Budget constraint in nominal terms:

PtCt+Bt+PtKt+Mt=wtLt+it-1Bt-1+rt-1PtKt-1PtCt+Bt+PtKt+Mt=wtLt+(1+it-1)Bt-1+(1+rt-1)PtKt-1+Mt-

1

PtCt+Bt+PtKt+Mt=wtLt+(1+it-1)Bt-1+(Rt-1/Pt+1-)PtKt-1+Mt-1

PtCt+Bt+PtKt+Mt=PtAtF(Kt-1, Lt)+(1+it-1)Bt-1+(1-)PtKt-1+Mt-1

The budget constraint Budget constraint in real terms:

11 1 1

t t t tt t t t t t

t t t t

B M w BC K L i r K

P P P P

1 11 1 1(1 ) (1 )t t t t t

t t t t t tt t t t t

B M w B MC K L i r K

P P P P P

1 1

1 11

( , ) (1 )

(1 )

t tt t t t t t

t t

t tt

t t

B MC K AF K L K

P P

B Mi

P P

Choice of future assets Future rates of return: it and Rt

They are determined by future market conditions; Future price level: Pt+1

It is determined by future market conditions; Real rates of return:

(1+it)Pt/Pt+1-1 and Rt/Pt+1-; The choice of Bt and Kt is based on expectation

s on future rates of return and future price level.

Real Business Cycle Money is left untreated:

Assume that Mt=M;

Assume that Pt=P;

It follows that it-1=rt-1.

Household budget constraint:PCt+Bt+PKt=wtLt+it-1Bt-1+rt-1PKt-1PCt+Bt+PKt=PAtF(Kt-1, Lt)+(1+it-1)Bt-1+(1-)PKt-1

11 1 1( , ) (1 ) (1 )t t

t t t t t t t

B BC K AF K L K i

P P

11 1 1

t t tt t t t t t

B w BC K L i r K

P P P