Lecture 8: Markets, Prices, Supply and Demand I

L11200 Introduction to Macroeconomics 2009/10

Reading: Barro Ch.6 11 February 2010

Introduction

• Last time:– Finished the Economic Growth topic by

considering ‘Long-Run Growth’– Continuous technological progress most

convincing explanation for long-run growth

• Today– Begin topic on fluctuations– Set foundations for model of fluctuations

Fluctuations

• Why fluctuations matter• Cyclical pattern in GDP growth matched by

cyclical pattern in:– Employment, Unemployment and hours of work– Consumption Spending and Investment– Inflation and price movements– Interest rates– Government Spending and Debt

Modelling Fluctuations

• To model these we need a model in which agents make choices over– Hours of work, and work/non-work choice– Consumption now versus saving for later– Investing now versus taking profits– Government spending and taxation

• So need model in which microeconomics of consumers, firms and governments are joined together

Basic Model Setup

• Basic element in the model is the ‘household’– Owns a small business: uses capital and labour to

produce output– Supplies labour (to itself, and maybe to others)– Owns capital (and can also rent / lease capital)– Earns profit, which it consumes / saves in bonds

• Assume households are price takers, i.e. perfectly competitive markets

Perfect Competition

• So economy is populated by perfectly competitive firms– Implies profit will equal 0 in equilibrium– Do not model monopolistically competitive /

monopoly / oligopoly firms in the economy (yet)– But have now connected the firm to the

household: also a consumer and a supplier of labour and an owner of capital.

Household Activities

• Households:– Produce output via the production function

– They employ themselves and then hire extra labour / sell their extra labour if they want to

– They own some capital K, and hire extra capital / lease extra capital if they want to

– Initially assume that the supply of L and K is perfectly inelastic: all labour and machines are used all of the time (will relax this later)

( , )d dY A f K L

Household Activities

• They use their profit + wage income + rental income to:– Consume: only non-durable goods consumed– Invest: buy more capital for production– Save: save their income in a risk-free bond (i.e. a

savings account)– Return on bond = marginal product of capital.

Prices

• Households produce an output which can either be invested, sold or consumed– Each unit of output can be sold at a price P– Value of consumption = C (number of units

consumed) x P (price per unit)– Value of investment = K (number of units of

capital bought) x P (price per unit)– So the price level P applies to both one unit of

consumption and one unit of capital

Household Income

• Income components: profit, wage, rent, return on savings (income from bonds)– Profit = income from sales – wage – rent

– Wage – Income from leasing capital:– Interest on savings (bonds):

( )d dPY wL RK

( ( , ) ( )d d d dP A f K L wL RK wL

( )i PK

( )i B

Household Spending

• Spending: Consumption, Investment, Bonds– Consumption:– Investment in new Capital: – Investment in new bonds:– So if investment in new bonds is negative, the

household is spending their savings (i.e. B is reduced to fund either consumption or buying new capital)

– The value of bonds is a monetary value

PC

P KB

Money Holding

• Missing element is ‘cash’ money– Money in our economy is ‘paper money’: a

medium of exchange which can be used to buy output, capital, bonds and pay wages (to labour) and rent (to capital).

– Household money demand is constant (relax this later)

– Total quantity of money is economy is constant (relax this later)

Budget Constraint

• Now we can put together the household budget constraint:

nominal consumption + nominal saving = nominal income

( )PC B P K wL i B PK

(price per unit of consumption x number of units consumed) + change in value of bonds + new spending on capital = profit from the household business + wages earned supplying labour to the household business or others + rent earned leasing capital to the household business or others

What is this?

• A budget constraint is an accounting equation which describes the limits of the household activities:– The right-hand side is income– The left-hand side is spending (including spending

savings)– So the two sides must match! This equation has to

balance each and every period

Budget Constraint in Real Terms

• To find budget constraint in real terms, divide all nominal values by P:

• This will become relevant when we consider how changes in the money supply affect prices

• For the time being money supply is fixed.

(1/ ) / ( / ) ( / )C P B K P w P L i B P K

Household Behaviour

• The budget constraint describes household income / expenditures. Questions now are:– How much does household choose to:– Consume– Save in bonds– Invest in new capital– Produce– (note we assume L is fixed: household will always

work constant hours)

Summary

• Have built the basics of the macroeconomy– Basic unit is the producing, consuming, labour

supply, capital holding, household– Described the household activities and sources of

income / types of expenditure

• Next time: begin modelling behaviour– Consider how much the household produces (and

so how much labour and capital they use)– Then consider what they do with their income..