Markets, Prices, Supply, and Demand

Markets, Prices, Supply, and Demand Macroeconomics - Barro Chapter 6

Markets in the Macroeconomy • The Goods Market Firms operate a production technology and use labor, L, and capital, K, to produce goods, Y, through the production function. Y= A· F( K, L) Macroeconomics - Barro Chapter 6

Markets in the Macroeconomy • The Goods Market • SUPPLY: Firms sell all the goods they produce on a goods market. Y = sales • DEMAND: Households buy goods for • consumption. • to increase the stock of goods in the form of capital used for production, called investment. Macroeconomics - Barro Chapter 6

Markets and Prices • The Goods Market • The price in this market, denoted by P, expresses the number of dollars that exchange for one unit of goods. We call P the price level. • For a seller of goods, the price level, P, is the number of dollars obtained for each unit of goods sold. • For a buyer, P is the number of dollars paid per unit of goods. • Since P dollars buy 1 unit of goods, $1 buys 1/P units of goods. Macroeconomics - Barro Chapter 6

Markets in the Macroeconomy • The Labor Market • SUPPLY: Households supply labor on a labor market. • Assume that the quantity supplied, Ls, is a constant, L. Macroeconomics - Barro Chapter 6

Clearing of the Markets for Labor and Capital Services • The Labor Market • DEMAND: • ∆(π/P) = ∆[ A·F( Kd, Ld) ] − w/ P • = MPL − w/P • change in real profit= marginal product of labor− real wage rate Macroeconomics - Barro Chapter 6

Markets and Prices • The Labor Market • Households sell and firms buy labor in the labor market at the dollar or nominal wage rate, w. • The real wage rate is w/P. Macroeconomics - Barro Chapter 6

Clearing of the Market for Labor Services Macroeconomics - Barro Chapter 6

Clearing of the Market forLabor Services • Supply of labor • We are assuming that each household supplies a fixed quantity of labor to the labor market. • Therefore, the aggregate or market supply of labor, Ls, is the given amount L. Macroeconomics - Barro Chapter 6

Clearing of the Market for Labor Services • Clearing of the labor market • w/P is determined to equate the aggregate quantity of labor demanded, Ld, to the aggregate quantity supplied, L. • ( w/ P)* = MPL ( evaluated at L) Macroeconomics - Barro Chapter 6

Clearing of the Markets for Labor Services Macroeconomics - Barro Chapter 6

Markets in the Macroeconomy • The Rental Market or Market for Capital Services • SUPPLY: Each household rents out all of the capital that it owns on a rental market. • We think of the capital offered on the rental market as the supply of capital services, Ks. Since we have assumed that each household rents out all of its capital, we have Ks= K. Macroeconomics - Barro Chapter 6

Markets and Prices • The Rental Market or Market for Capital Services • DEMAND: Firms rent out capital, K, for dollars at the dollar or nominal rental price, R • A firm that rents the amount of capital Kd pays the nominal amount RKdper year and then gets to use the capital as an input to production. • The real rental price is R/P. Macroeconomics - Barro Chapter 6

Clearing of the Market for Capital Services • The Market for Capital Services • Demand for capital services • ∆(π/P) = ∆[ A·F(Kd, Ld) ] − R/P • = MPK − R/P • change in real profit= marginal product of capital− real rental price Macroeconomics - Barro Chapter 6

Clearing of the Market for Capital Services Macroeconomics - Barro Chapter 6

Clearing of the Market forCapital Services • The Market for Capital Services • Supply of capital services • For the economy as a whole, the aggregate quantity of capital, K, is given from past flows of investment. • In the short run, the aggregate or market quantity of capital services supplied, Ks, equals K. Macroeconomics - Barro Chapter 6

Clearing of the Market forCapital Services • The Market for Capital Services • Clearing of the market for capital services • R/P will be determined to clear the market—that is, so that the aggregate quantity of capital services supplied, K, equals the aggregate quantity demanded, Kd • (R/P)* = MPK( evaluated at K) Macroeconomics - Barro Chapter 6

Clearing of the Market forCapital Services Macroeconomics - Barro Chapter 6

Markets in the Macroeconomy • The Bond Market • A borrowing household receives a loan from another household, whereas a lending household provides a loan to another household. • A household that makes a loan receives a piece of paper called a bond, and we call the market on which households borrow or lend the bond market. The holder of a bond, the lender, has a claim to the amount owed by the borrower. Macroeconomics - Barro Chapter 6

Markets and Prices • The Bond Market • Each unit of bonds commits the borrower to repay $1 to the holder of the bond. This $1 is the principal of each bond. • The principal is the initial amount advanced on a loan. • All bonds have very short maturity, Macroeconomics - Barro Chapter 6

Markets and Prices • The Bond Market • Each unit of bonds commits the borrower to pay the holder a flow of interest payments of $i per year. • The variable i is the interest rate, which is the ratio of the interest payment, $i, to the principal $1. • The interest rate, i, can vary over time. Macroeconomics - Barro Chapter 6

The Market for Capital Services and the Bond Market • The interest rate • i = R/P − δ • rate of return on bonds= net rate of return on ownership of capital • net rate of return = rate of return – depreciation rate • i = MPK ( evaluated at K) − δ Macroeconomics - Barro Chapter 6

Markets in the Macroeconomy • The Money Market • We assume that the exchanges on each of these markets use a single form of medium of exchange that we call money. Macroeconomics - Barro Chapter 6

Markets in the Macroeconomy • The Money Market • Assume that money is just a piece of paper, analogous to a paper currency issued by a government. • Money is denominated in an arbitrary unit, such as a “dollar.” • Dollar amounts are in nominal terms. • Paper money earns no interest. Macroeconomics - Barro Chapter 6

Markets in the Macroeconomy • The Money Market • The sum of the individual holdings of money equals the aggregate quantity of money in the economy. • Assume, for now, that this aggregate quantity of money is a given constant. • The total money held by all households must end up equaling this constant. Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • The quantities and prices determined on these markets will determine household income. • Flows of income are sources of funds • Purchases of goods and assets are uses of funds • The total sources of funds must equal the total uses of funds. This equality is called the households’ budget constraint. Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Income • Profits • Households may earn profits—an excess of revenue over costs—as shareholders of the firms in the economy. • Y= A· F( Kd, Ld) • π= PY − (wLd+ RKd) • π = P .A· F( Kd, Ld) − ( wLd+ RKd) • π= P.A· F(K, L) − MPL· P· L − MPK· P· K Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Income • Wage income • If households supply the quantity of labor Ls to the labor market, they receive the nominal wage income of wLsper year. • Quantity of labor supplied is the fixed amount L, so nominal wage income is wL. Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Income • Rental income • If households supply the quantity of capital Ksto the rental market they receive the nominal rental income of RKsper year. • Since households supply all of their available capital, K, to the rental market, so that Ks= K, the nominal rental income is RK. Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Income • Rental income • The quantity δK of capital disappears each year. The dollar value of this lost capital is P· δK. • net nominal rental income= nominal rental income− value of depreciation • net nominal rental income = RK − δ P K • net nominal rental income = (R/ P)·P K − δ P K • net nominal rental income= ( R/ P − δ) · P K • rate of return on owning capital= R/ P − δ Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Income • Interest Income • If a household’s nominal bond holdings are B, the flow of nominal interest income received is iB per year. Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Total income • Household nominal income = π+ wL + (R/P − δ) · PK + iB • In considering whether to hold assets as bonds or capital, households would compare the rate of return on bonds, the interest rate, i, with the rate of return on ownership of capital, R/P − δ. • Rate of return on bonds= rate of return on ownership i = R/ P − δ • Household nominal income=π+ wL + i·(B+ P K) Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Consumption • Households consume goods in the quantity C per year at price= P • Household nominal consumption= P C Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Assets • Households hold assets in three forms: • money, M; • bonds, B; • ownership of capital, K. Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Assets • We assume that households hold a fixed amount of money in dollar terms; that is, we assume that the change over time of a household’s nominal money holdings is zero • ∆M=0 Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Household Budget Constraint • nominal value of assets= M+ B+ P K • nominal saving: the change over time in the nominal value of assets. • nominal saving= ∆M + ∆B + P·∆K Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Household Budget Constraint in Nominal Terms • PC + ∆B + P·∆K = π+ wL + i·( B+ P K ) • nominal consumption + nominal saving = nominal income Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint • Household Budget Constraint real terms C + ( 1/ P)·∆B+ ∆K = π/ P + ( w/P)·L + i·(B/P+K) • consumption + real saving = real income Macroeconomics - Barro Chapter 6

Constructing the Budget Constraint Macroeconomics - Barro Chapter 6

Macroeconomics - Barro Chapter 6

Markets, Prices, Supply, and Demand