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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: B t -1 , K t -1 , P t -1 , M t -1

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Chapter 6 Markets, Prices, Supply, and Demand

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  1. Chapter 6 Markets, Prices, Supply, and Demand

  2. 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.

  3. 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.

  4. 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.

  5. 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

  6. 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.

  7. Markets in the Macroeconomy • The bond market: borrowing between households. • The money market • Inelastic supply of money: Ms=Mt; • Household demands md=Md/Pt.

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

  9. Markets and Prices • The money market • The general price level: Pt. • The labor market • Nominal wage: wt. • Real wage: wt/Pt.

  10. 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 market • Nominal interest rate: it-1. • Nominal interest income: it-1Bt-1. • In aggregation, the net borrowing must be zero.

  11. 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.

  12. 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: .

  13. 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

  14. The Budget Constraint • Household budget constraint • Nominal value of assets: Mt-1+Bt-1+PtKt-1. • Nominal saving: Mt+Bt+PtKt • Budget constraint in nominal terms: PtCt+Bt+PtKt+Mt=t+wtLt+it-1Bt-1+rt-1PtKt-1 • Budget constraint in real terms:

  15. The Budget Constraint • The budget line

  16. 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.

  17. 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:

  18. Market Clearing • Labor market clears

  19. 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:

  20. Market Clearing • Market of capital services clears

  21. Market Clearing • Zero profit at equilibrium

  22. The budget constraint • Budget constraint in nominal terms: • PtCt+Bt+PtKt+Mt=wtLt+it-1Bt-1+rt-1PtKt-1 • PtCt+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

  23. The budget constraint • Budget constraint in real terms:

  24. 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+1-1and Rt/Pt+1-; • The choice of Bt and Kt is based on expectations on future rates of return and future price level.

  25. 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+PKt=wtLt+it-1Bt-1+rt-1PKt-1 • PCt+Bt+PKt=PAtF(Kt-1, Lt)+(1+it-1)Bt-1+(1-)PKt-1

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